Welcome to the weekly report. This week we look at the Bank for International Settlements (BIS) latest utterances and look at the chart of a hedge Fund showing unusual price action. We start with a look at some "suggestions" made by the BIS in its 78th annual report. This is probably the most important global macro-economic pointer you will see this year that shows the way ahead:

• "Most of the more specific suggestions for government involvement have been directed to alleviating the likelihood of a full-blown credit crunch in global financial markets. What is sought are ways to mute the potentially powerful interaction between uncertainty about the solvency of borrowers, primarily households, and the solvency of lenders. In fact, steps have already been taken in the United States to use government and quasi-government agencies to support mortgage markets, and thus indirectly house prices, homeowners and lenders as well. In a number of countries, there have been calls for direct government purchases to put a floor under the prices of a variety of financial instruments.

  Of course, this conflicts directly with the need for the market to find its own level if it is eventually to function normally again, and exposes the government to future losses should prices continue to fall regardless. Another approach to the problem focuses not on households' assets but on their liabilities, and suggests that there should be a form of blanket reduction based on certain principles established by governments.

  The downsides of course are evident: the potential direct cost to the government, the moral hazard involved, and the political outrage as "prudent" borrowers and taxpayers are forced to subsidise the "imprudent".

  How might governments help in reducing uncertainties about the solvency of banks and, in turn, the threat of a credit crunch? Evidently, the first step would be to encourage self-help. Both dividends and bonuses should be cut in order to increase capital cushions. The private sector, whether through rights
  issues or appeals to outside investors, should also be turned to for further capital injections. This process would clearly be facilitated by greater clarity as to the need for capital, in the light of prospective losses and also possible involuntary increases in balance sheets.

  The problem, however, is that the valuation of many structured products is difficult, because there is effectively no market for them, and valuing them using models has many drawbacks. The suggestion that banks might agree on a common "template" for valuations, recognising these shortcomings, nevertheless has significant merit. Of course, such an evaluation might also reveal that the losses are uncomfortably large, a possibility for which the authorities should make preparations in advance.

  One response, if the regulatory authorities were able to determine that the estimated "fair value" losses were much greater than seemed likely to be realised in the end, might be a temporary degree of regulatory forbearance. Conversely, and perhaps more likely, if the regulators felt unable to do this, then the government should not hesitate to intervene directly subject to the principles laid out above.

  Mergers, takeovers, the establishment of a "bad bank" to house bad assets, recapitalisation using public funds and even nationalisation are all procedures that should be contemplated depending on the circumstances.

  When direct public sector intervention seems required, the domestic legal framework and the potential need to involve foreign authorities will be important factors constraining what might in practical terms be done. In such circumstances, it is likely to become evident quite quickly that not enough effort has been put into preparing for the possibility of a financial crisis of some sort. If the authorities must muddle through regardless, the experience will at least provide some indications of what preparations might have been better made in advance."

Let's be straight on this, the deleveraging we have seen since the summer of '07 is the natural consequence of prices being affected by a higher than expected level of risk occurring in the markets. It started with the reduction of banks willing to lend short term loans, commercial paper, to each other as the prices of the assets used to secure the loans began to drop markedly. Those assets were being re-priced lower to more realistic levels as the expected income they earned did not match the modelled expectations.

With a lack of short term loan facilities banks who borrowed short to leverage lending long found the business model collapsing. There were only 2 options left, either raise capital to allow leverage to continue or to stop the long term lending and reduce the amount of leverage in use.
As we have seen over the past year most banks have attempted to raise capital by begging cash rich Sovereign Wealth Funds, Private Equity or cash rich Institutions to "buy" part of the bank, promising to pay usury rates in return. Or they have issued more equity, diluting share-holder wealth. This is what nearly all the banks have had to do. Some more than once.

The likes of Countrywide, Bear Stearns, a myriad of Mortgage Lenders and a whole bunch of Hedge Funds (Peloton etc) took the second option and stopped the process, or had it stopped for them by a market no longer willing (or able) to allow their business models to continue.

So here we are today, with Bankers wearing brown trousers to work to disguise the fear, the Primary Brokers looking directly into the regulatory future they dread and Hedge Funds hoping they have enough credit available to stay afloat. The actions taken by the Fed, Bank of England et al are now seen as "holding operations" allowing current practises to continue until the dawning of a new way, putting a line under the mess with a new paradigm that will define the next chapter in capitalism.

Whilst the "new way" is awaited, the de-leveraging continues and those invested in the Bank/Broker sector sell out on any rally.
It is that chapter that the BIS started to outline. We should plan for the following events (if you think this is far-fetched, remember the reaction when the Fed started its "Facilities"?):

• 1. Direct government purchases of a variety of financial instruments allowing market intervention and price fixing.

  2. Debt relief for those with liabilities, either through arrangement with the commercial banks or imposed by government probably through the use of direct cash infusion.

  3. A manoeuvre that allows the erosion of net worth to be blamed on a non-governmental body through increased pan-government legislation.

  4. If banks have to raise capital by dividend and bonus cuts then they will expect the same of corporations who are indebted to banks to facilitate re-payment and debt servicing.

  5. The closing of markets by government edict (over-ruling central banks and regulators) that are deemed to be "incapable" of the fair pricing of assets and long term pricing agreements allowed to be reflected in bank balance sheets.

  6. If in doubt nationalise the troubled entity without compensation to investors.

  7. Finally, governments should enact new laws to allow all the above to take place as soon as possible. As these new laws will be wide ranging then they should be allowed to cover all and every contingency.

Did you read the above list and start mentally ticking off which of those actions had already happened? Not so far-fetched after all...........

The chart of a Hedge Fund caught my eye this week. Man Group, one of the biggest, is showing some unusual action:

Notice the holding action before the break down out of the wedge? I suspect a visit to 484p is on the cards, maybe lower.

That's all for this week, shorter than usual I'm afraid but I have run out of time.

Welcome to the Weekly Report. This week we get so bearish that even I worry that my personal sentiment indicator may have reached an extreme. We tie up some loose ends and recap Citigroup.

"The opera ain't over until the fat lady sings." Singing? I doubt there is a bear in the world that isn't humming the Ride of the Valkyries as the charts tell a tale that will scare your grandchildren. It's looking ugly and has the potential to get downright repulsive. That potential shows up when a longer term view of the charts is taken. This week we look at banks, more specifically those banks that participated or later merged/bought/bailed out with banks that helped liquefy the LTCM rescue. To counter-balance my bearish tendencies, I want to look for potential support areas for banks, places where the current collapse in share prices might come to a halt.

Before we start I want to flag up a couple of previous articles, one by me and another by Adrian Burridge. Both articles were written back in January / February and refer to Citi and the mess it is in, you might find them a handy precursor.

As I mentioned, its time to tie up some loose ends and see if we can identify some possible support for banks. Like Adrian, I see much of the problems today connected to the LTCM debacle, the method used to bail it out and the forgetfulness of bank management. This from Wikipedia (hey, if we use Fed/Govt stats, why not Wiki?):

• "Goldman Sachs, AIG and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman Sachs's own trading. The offer was rejected and the same day the Federal Reserve Bank of New York organized a bail out of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The contributions from the various institutions were as follows:

  $300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS

  $125 million: Société Générale

  $100 million: Lehman Brothers, Paribas

  Bear Stearns declined to participate.

  In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established.

  The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their own debt creating a vicious cycle.

  The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):

  $1.6 bn in swaps

  $1.3 bn in equity volatility

  $430 mn in Russian and other emerging markets

  $371 mn in directional trades in developed countries

  $215 mn in yield curve arbitrage

  $203 mn in S&P 500 stocks

  $100 mn in junk bond arbitrage

  no substantial losses in merger arbitrage"

Small sums when compared to what the banks have been writing down of late but these amounts were on top of what the banks position losses in LTCM were. There was a self interest to be served in the LTCM bail-out, banks were able to cover their liabilities, not dissimilar to some theories behind the Bear Stearns and Countrywide buy outs.

Banks ended up with positions that needed to be worked on as well as building capital to cover the bail-out costs. Unfortunately, the good times hadn't finished rolling on and banks began to merge and buy each other, accompanied with large scale management changes and the need to sort out the LTCM legacy was downgraded or forgotten about. It was a time to maximise profits as the dot.com bubble reached toward its zenith, greed took the place of probity. With 10 years to sort out the problem, most management in 1999-2001 probably thought the problem would be for someone else to sort out.

Why 10 years? Here is a snippet from Adrian's article, Long Term Capital and Citigroup:

• "LTCM had over $1 trillion in notionals according to published reports. 10 years ago was 1997. They were active in 10 year swaps. Very active. Swaps don't get unwound. They go to maturity and the losses are reported at maturity."
  

Oh dear, it looks to me that the problem was not only put off till later but eventually forgotten, except by one or two individuals and quite possibly one bank. So, $1Tn in 10year swaps matured, along with any counter-party positions taken against them in 2007. As Adrian remarks in his article, no wonder LIBOR moved the way it did and credit markets imploded.

So if we use LTCM as a baseline, the beginning of the massive expansion in the credit derivatives market as recognised by The Bank of International Settlements in its 2007 triennial Survey:

• "Growth accelerated in all risk categories. The highest rate of increase was reported in the credit segment of the OTC derivatives market, where positions expanded to $51 trillion, from under $5 trillion in the 2004 survey."
  

Yep in 3 years credit derivatives went up 10 fold, all of it is invented, electronic, unbacked fiat currency liabilities. If you want to scare yourself on a dark, windy night as the wolf howls outside the door, read this and cower. It's the song sheet that the fat lady grips tightly to her heaving bosom as she reaches a crescendo. LTCM may well be the first "ripple though" event faced by credit derivative markets and probably the smallest.

The BIS reports have changed over the years as some markets became less important and others grew. Here is a quote from the BIS OTC Derivatives Market at the end of June 1998:

• "Allowing for netting lowers the derivatives-related credit exposure of reporting institutions to $1.2 trillion, or to 11% of on-balance-sheet international banking assets."
  

The figures for 2004-2007 are netted too. So did the expansion begin with the collapse of LTCM? Surprisingly, no - this from the same report, dated end December 1998:

• "Allowing for netting, the increase in the derivatives-related credit exposure of reporting institutions was much smaller, rising by $0.1 trillion to $1.3 trillion (or to 12% of on-balance sheet international banking assets)."
  

The expansion clearly begins after LTCM, probably as banks decided to inflate the credit derivatives market in an attempt to bury the losses and reduce them to an insignificant amount. No wonder credit itself became so easy to obtain, it was needed to allow the growth of the derivatives, the basic liability and income streams upon which the derivatives are based. Once the explosion of CDO,CDS,MBS,ABS et al (google them if you don't know what they are) occurred and not forgetting that the derivatives themselves have been used as the building blocks for other derivatives, the inevitable bubble, peak and burst were just a matter of time. Unfortunately for the banks, they forgot when that time was.

At the time of LTCM it was interest rate swaps that were the preferred tool with particular concentration in 3 currencies:

• "Much of the expansion in business over the review period can be attributed to the financial turbulence that followed the Russian debt moratorium and the near-collapse of LTCM. This was particularly true in the interest rate segment, where the widespread unwinding of leveraged positions led to an upsurge in interest rate swaps. The increase in interest rate contracts was particularly pronounced in the Deutsche mark (42%), yen (36%) and Swiss franc (25%) segments. While this reflected the ongoing development of derivatives markets outside North America, in the case of the mark it may have been related to the growing benchmark role of German instruments"
  

Here it gets murky. Were those swaps used as the basis, the collateral, for an increase in reserves to allow the growth of lending which facilitated the expansion of credit derivatives? Did the introduction of Basel 2 cause those swaps to be re-categorised to level 2 or level 3 assets, requiring a rebuilding of reserves and/or a reduction in leverage and lending? Was the maturing of those swaps and the positions built upon them the straw that broke the camels back? Are the actions of Federal Reserve and all the other Central Banks (ECB, Swiss, UK and Japanese "largesse") the returning home of a problem that began in 1998?

It's murky because not only do I not know but I suspect neither do the Central Bankers. What I do know is the concentration of exposure is not as the BIS expected back at the end of 1998:

The development of the Credit Default Swap market moved the risk into a very concentrated "G7" oriented pattern of distribution. The risk in emerging markets has been kept at levels that can be understood and with their relatively small size much easier to regulate and police. Without knowing the counter-parties, the agreed timelines and the triggering events involved in CDS contracts it will become much more difficult to price risk.

Maybe it's better not to know. More worryingly is the continued expansion, especially since H1 07, of the CDS market. Its no coincidence that a massive move to lay off risk accompanied the credit crash and the Bear Stearns implosion (which did not happen in March this year). The table below shows that expansion and the timescale. Elliott wavers (and Gann followers) are going to love this one:

CDS nearly tripled in 6 months. These 5 year on the run instruments will expire in…..2012. Now they may well be traded out before then but I doubt a single EW'r didn't smile on seeing this.

Finally the banks, here is a selection of monthly charts, showing what I think are important support and resistance levels. I have marked the LTCM event on the charts. As you can see if "LTCM" does not hold, banks have a lot further to go.

We start with Citigroup:

Goldman Sachs:

Bank of America

JPM:

Barclays:

UBS:

That's it for this week, don't forget the long term trends in this market, they are in play and identify some fundamental areas.

This week I want to aim the article at those who normally do not frequent financial bulletin boards or sites. You, the reader, need to help me in this cause.

People who read financial BB's are already interested and to some extent (though not always) informed about how certain economic conditions occur and can hold a healthy debate about the cures for such ills.

However we are a small group of independent thinkers, we exist at the margins where we try and do our best to inform the public about the dangers and benefits of our financial system. How many of us have watched our family and friends adopt a fixed grin and a glazed expression as we try and explain the complicated world of money flows, interest rates, inflation, deflation etc? We all know the moment when they stopped listening; it was when they started looking over our shoulder to see if there is someone more interesting standing behind us to talk to.

This Weekly Report is for those who glaze over. The trouble is the target audience doesn't read my website or these financial boards. So this week I want you to do a little something for me, send this article to your friends, the ones that now know something is wrong but don't realise what the problem is. It will be available, in full, on my old blog here.

However, before I start the article proper I want to share a little something with you. In April I wrote a series of articles about G B Eggertsson and how his paper "An interpretation of The Deflation Bias and Committing to Being Irresponsible" was being used by the Federal Reserve as the plan to escape from the deflationary effects of the credit crash. Three of the articles were subscriber only but I have now enabled those articles to be read in full without subscription of any sort at An Occasional Letter From The Collection Agency.

That's it, the second to last mention of my site in this article, you have permission to cut and paste this article from here (see the acknowledgement at the end) if you wish to send on to your friends and relatives who you think need to know what is coming. Reproduction on other sites is allowed too. This article uses the US and to a greater extent the UK to describe the background. It is applicable to all countries that allow a fiat currency.

How did this happen?

You will have heard of the sub-prime defaults, that credit conditions have changed, that banks are struggling. All these things are the not the cause of the current problems but are the symptoms of a system that allowed itself to become a one way bet, a self reinforcing merry-go-round of increasing debt. Let me show you how it works and how it breaks.

Mankind has only ever truly created one thing, fiat currency. Fiat currency is cash, paper and coins that are only backed by confidence, for paper they are promises to pay the bearer, coins have an intrinsic worth depending on the metals used to make them.(Hence why coins have become smaller and lighter over the years, production costs need to be below the notional worth of the coin). Paper has practically no intrinsic worth, except to paper recyclers.

Mankind can produce as much paper and coins as it wishes and since it is all based on promises, these days you don't even need a note, you can electronically promise "cash" too. Think about a mortgage payment. It is paid by an electronic transfer of an amount out of your bank account to the mortgage lender. The "cash" was originally placed in your account to be able to make the mortgage payment by electronic transfer from the account of your employer or your interest bearing savings / investment account. No real paper was used, no bags of coin delivered. It all happened electronically.

You can see the temptation such a system offers. You can invent money, lend it to others who pay you interest and at the end of the term you get the principal back too. You do not need to have any collateral to make this happen, though we do have regulations for banks that say they must have a reserve amount that is a percentage of the amount of money they invent. As all money in a fiat system is invented and relies on confidence, it doesn't really matter if reserves really exist or not, except to fulfil regulatory requirements.

Let me show you the system in this simplified diagram:

At the basic level the system is that simple. As long as the costs and defaults are exceeded by the profit made from the interest received your reserves grow and enable higher levels of leverage. You can get very rich doing this.

However every so often in human history events make this simple idea break down. It doesn't matter what the event is but if it makes the costs higher that the interest received then the reserve shrinks. This stops the increasing levels of lending and in severe cases can cause lending levels to fall or even stop altogether.

This is what we call a credit crisis. They have happened before and caused the bankruptcy of many lenders. Those that survived such events usually did so because they refused to allow indiscriminate lending, they applied standards to borrowers, checking to see if they could repay loans and refused to leverage to the maximum potential.

If an economy is reliant on the ability to borrow to achieve purchasing power or increase productivity then a credit crisis has an enormous impact, stopping growth and commercial activity. This worries bankers who have no wish to join the list of "also ran" names of yesteryear. So they decided to try and protect their business model and move some, or all, of the risk to another sphere of the financial system. To do this they had to make such risk taking attractive to others by offering compensation.

Again, here is our simple model but with a basic level of protection added:

You can see what has happened; the original bank lending system now looks stronger as the risk is lowered at the expense of some of the interest income. But notice how the model now becomes acceptable to the Insurer who can use the new income to raise their own reserves. What was a very simple model has now, with one change, morphed into a multi-party system that can be continuously expanded as risk is offloaded to other parties.

So what can go wrong?

• 1. Interest income does not cover costs.

  If the amount of interest charged is too low to cover costs, interest rates on variable products can be raised. If the product is fixed rate then either customers can be encouraged to take variable rates that can be reset higher (after a lower introductory offer) or the debt can be packaged together and sold on to another party at a discount.

  2. The principal may not be repaid.

  The bank will invoke its insurance policy to cover the losses if the principal worth is calculated to have dropped below a certain level previously agreed with the Insurer. The payout can then be added to the reserves to ensure the bank complies with regulations.

  3. Regulations change.

  If the governing body decides that banks need to hold a higher percentage of reserves compared to lending then capital must raised to boost the reserves (e.g. Basel 2). This can be achieved by borrowing, rights or bond issues or by reducing the amount of lending.

Any one of these circumstances alone would not cause bankruptcy. Even a half decent capitalised bank could survive 2 of these events running concurrently. However if banks (and the Insurers and other lenders) have stretched the leverage out to 20, 30 or 40 times reserve capital and all 3 of these circumstances arrive at the same time you then have a credit crisis.

Remember the financial system relies on confidence. If confidence in the survivability of the system or part of the system is impaired then the structure slows and stops. In an extreme crisis the system may well go into reverse. Sub-prime became the headline for the current crisis but it is just a manifestation of the events above all occurring at the same time:

In many ways the 3 events almost seem to have been perfectly timed to cause the maximum damage, with rates moving higher from 2004 to 2006, just as many sub prime, Alt A and jumbo mortgages began to reset from teaser rates to higher nominal rates. In 2007 and 2008 capital requirements and the accounting and pricing of assets changed as Basel 2, sponsored by the Bank of International Settlements (BIS) came into force.

Certainly anyone in an informed position could have seen that the situation was set to deteriorate rather than stabilise. Without doubt the effects of these events where under-estimated by those charged with ensuring the Financial and Monetary system remained fit for purpose.

How is the financial system made fit for purpose?

Let me say that the methods used to make the credit system work again will be the same as those employed previously. Right now the world worries about inflation. Inflation is simply too much cash and credit chasing too few goods. Any asset or commodity that is in short supply will attract funds, causing the price of that asset to go higher.

The traditional method to control inflation is to raise interest rates, causing cash to be saved as returns become attractive and restricting the use of credit as it becomes prohibitively expensive. However there is another method that can be used.

Think of cash/credit as an asset. If you want the price of an asset to rise you make it scarcer, you restrict the amount available. As cash becomes more valuable the amount needed to buy less scarce assets drops. A s we are talking about cash that means the price of commodities etc falls.

Are central banks restricting the flow of cash into the financial system? Here are the latest money supply M4 figures (£ billions) for the Bank of England (The Federal Reserve will follow the same path, in time):

Whilst the growth of M4 continues we can see a slowing in the growth rate. The amount of cash and credit available in sterling is slowing:

This slowing of issuance and availability makes sterling more valuable, especially if the interest rate is attractive (this is the overnight interbank rate for sterling from Jun 07):

Notice the falling interest rate coincides with the slowing of M4 growth? As sterling becomes "rarer" the rate of return required on investment falls. Sterling itself appreciates, requiring less compensation in the form of interest. If you look back at the M4 growth chart, you can see that the 3 month rate of growth has been lower than the 12 month rate for some time (the blip in March was the second round credit crunch effects liquidity "save"). If the 3 month ROG remains like this then growth of the amount of sterling will continue to contract over the medium (12-24 months) term.

This is an anti-inflationary move by the Bank of England, yet the rhetoric over recent days has been about inflation fears. The increased rhetoric is to counteract inflation expectations and the fear that a widespread demand for greater wage increases will take hold, as the Bank of England Governor, Mervyn King, alluded to in a speech last week:

• "The immediate cause of the current pickup in inflation is increases in food and energy prices relative to other prices. They are caused by the pressure of demand on the supply of food and energy in the world as a whole. Part of that pressure may well reflect expansionary monetary policy in the world as a whole. But the rise in commodity prices cannot, by itself, generate sustained inflation in the United Kingdom unless we allow it to. We will not. So although inflation in the UK will rise in the short term, inflation will then fall back.

  That means that the rate of increase of other prices and domestic costs, notably pay, must remain low. The MPC does not take that for granted. Surveys - including our own -indicate that expectations of inflation have risen, meaning that inflation is likely to have some tendency to persist. That is why, as I explained in my letter to the Chancellor, we believe that a slowdown in the economy this year, creating a margin of spare capacity, will be necessary to dampen price and wage pressures and ensure that we fulfill our remit by returning inflation to the target. And growth is now slowing quite sharply - broad money growth is falling, business surveys point to particularly weak output growth in the second quarter and growth is likely to remain subdued for the rest of the year."
  

Read that extract carefully, within it are terms couched for the ears of business and economists. The threat is that if inflation expectations lead to higher wage demands then interest rates will rise. However King then goes on to explain why he thinks the rising inflation expectations will be quashed:

• "we believe that a slowdown in the economy this year, creating a margin of spare capacity, will be necessary to dampen price and wage pressures"
  

In other words the cutting of M4 growth rates is being carried out to deliberately slow economic growth. By restricting the availability of cash and credit the economy will slow to a recessionary level where business will create a "margin of spare capacity" also known as unemployment. As I mentioned earlier the methods used to make the credit system fit for purpose are and will continue to be the same as those used previously.

The result, for ordinary mortals, will be an increasing difficulty in finding work, a greater fear that current employment may be curtailed and a reluctance to ask for higher wages. Savings will grow as non-essential spending is curtailed during an uncertain period, further reducing the availability of sterling circulating in the economy. Interest rates will remain high relative to discretionary income until the Bank of England decides that the Financial and Credit systems are once again fit for purpose.

The recession that will occur over the next 12-18 months is being deliberately engineered. Any growth in M4 will be redirected from the public to the banks, allowing the banks to repair their depleted reserves. Once these reserves are rebuilt lending standards will be loosened, allowing credit expansion to begin again. By that time interest rates will have been lowered, making the use of credit attractive, encouraging consumption and investment and helping GDP to expand. Another cycle of boom will then be initiated.

Less than 12 months ago the phrase "financial innovation" was still given credence, the "end of boom and bust" was still uttered to justify an economic third way. Now both phrases are discredited (pun intended) and have turned to ashes in the mouths of those who uttered them.

I have outlined above the truth of the current situation, how the greed of lenders caused a fatal weakness in the financial system and how ordinary people will have to deal with the results. A recession will be deliberately engineered to slow growth and allow banks to recover. As throughout history those that suffer in economic hard times are not those who profited in the boom. The masses will bear the burden and wonder what they did wrong to be placed in such hard times.

This article is to inform the public that the only thing they did wrong was to believe the rhetoric, the jawboning that was fed to them during the boom. The current situation is about to get much worse, it will not be due to higher wage claims, lack of productivity or uncompetitive practices. It will be because the politicians and bankers follow an economic system that is inherently flawed.

Until the public become educated about the way in which they are used to allow banks and governments to recover from "busts" and change the way they are led, then the banks and governments will continue to operate in their own interest, regardless of what becomes of the people. That education will not occur at the behest of governments or through the increased transparency of banking procedures and methods. It is up to us to try and let the people know what is happening. So use this article, reproduce it on blogs and sites and send it to others. All I ask is the following line is included:

Copyright: M Phoenix 2008. An Occasional Letter From The Collection Agency. Use of this article is unrestricted other than the inclusion of this acknowledgement.

Welcome to the Weekly Report. Let me take you on a journey to explain what Ben Bernanke said and why he said it. We look at yields, what they are telling us and why we should listen. Finally we show evidence that the carry trade is crumbling. You will require a hot beverage, peace and quiet and probably a light snack.

Its time for An Occasional Letter From The Collection Agency and this week I am delivering it to your door. We start off by looking at the recent remarks by Ben Bernanke that seemed to catch the markets unawares. Before that though I want you to realise that Bernanke was not speaking "off the cuff", indeed his remarks are part of the well organised execution of what I called the Eggertsson Theory, explained in "The future actions of the Federal Reserve are known. Eggertsson re-visited a question that The Federal Reserve has been mindful of for some number of decades and one that Bernanke himself studied in-depth:

• "Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no."
  

Now I wouldn't blame you for looking at such a question and thinking "more inflation?" but the title of Eggertsson's work is "The Deflation Bias and Committing to Being Irresponsible". It laid out the groundwork for an approach to defuse deflationary forces and how to re-inflate the economy. From my point of view, Bernanke is not worried by inflation but he is absolutely petrified about a deflationary event. The actions of the Federal Reserve have for some years (and well before last summer) been a consistent copy of the steps laid out by Eggertsson in how to avoid a deflationary episode. Bernanke's recent remarks are just another step in that plan. Allow me to quote from the link above:

• "Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:

  "The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ. To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years. Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility." Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)"

  At face value the remarks above would seem to support the Keynesian approach that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral.

  Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction.
  

  The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future.

  
  Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow). "
  

To be honest, you really do need to read "The future actions of the Fed etc" in full to see the whole picture. (it's on my old blog, not the website) but because human nature is what it is and most of you are pressed for time, I'll plough on regardless.

Again I quote from "The future actions etc":

• "It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago. The actions we have seen since August '07 are not the beginning of the attempted fix but the second stage.

  Since 2000:

  The US Government has run an increasing deficit.

  The Fed has allowed the movement of interest rates to compliment a notionally low interest rate environment. The withdrawal of M3 increased inflationary expectations.

  The loosening of regulatory oversight allowed a wider use of debt and increased consumption.

  Since mid 2007:

  The US Government has explicitly talked of increasing govt debt through tax rebates and targeting relief at overburdened indebted homeowners through the expanded use of Govt Sponsored Enterprises.

  The Fed cut interest rates aggressively below rates of inflation and introduced facilities to engender the outright purchase as well as the long and short term loans of cash and US Govt Bonds.

  The US Treasury does not rule out making the new Fed facilities permanent."

  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.

The Fed would be aware of the timetable, even if many other investors had forgotten, and may well have been planning for an LTCM debt redemption failure scenario. With investors being reassured that the financial system was "just fine" after the Amaranth collapse (which was nearly twice the size of LTCM) many would have glossed over the LTCM debt maturing. (As an aside, put 2016 in your diary….) Interestingly Bear Stearns did not get involved in the LTCM bail-out but they did hold a lot of CDS exposure, I'm not directly connecting the LTCM debt and Bears CDS portfolio directly but the coincidences are rather neat.

Back to the point, as I have covered here and in full in the article "The future actions etc" Bernanke was obliged to raise the rhetoric about inflation and inflation expectations as part of the plan to avoid a deflationary scenario. The raising of such a topic by Bernanke had to be seen as credible for it to work and that could only be achieved by prior Fed/Tsy inflationary actions being reflected in the actions and expectations that consumers and business displayed.

By continuing to talk up inflation, either through prices or by mentioning (finally) the dollar connection, he now has room to ready the US and the World for a series of hikes accompanied by a continuing delivery of cash and nominally priced assets. His hope is that the re-flation will stimulate growth whilst the yield curve remains steep but moves higher, especially the long maturities.

This, he believes, will encourage banks et al to start lending again as the reward would easily outweigh risk. He has already said this, I quote from "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression" by Bernanke as used in "New Keynesian Economics"(Mankiw and Romer Ch 29) and quoted in The Bernanke Conundrum:

• " "The effect of this credit squeeze on aggregate demand helped convert the severe..... downturn of 1929-1930 into a protracted depression"

  Bernanke goes on to identify various problems from the '20s that made the 29-30 downturn, which included the expansion of debt and in 1930 the move by banks out of the loan markets into more liquid instruments. Indeed the 1932 National Industrial Conference Board survey of credit conditions reported that the shrinkage of commercial loans in 1931 and the first half of 1932 represented pressure from the banks on customers for repayment and refusal by banks to grant new loans."
  

Without doubt Bernanke is extremely fearful that the current credit squeeze could have morphed any downturn into a depressionary episode. Having watched and the participated in the great re-flation following the stock market bear and 9/11, Bernanke would have known that conditions resembled the 1920's and that the aftermath of that burst combined with a credit squeeze led to the depression.

What will Bernanke watch to see if this latest step along the path laid out by Egerrtsson's Theory has been successful? In a word - yields:

Rates are acting as Bernanke would wish to see, the curve as a whole is rising. His only concern will be the long end; he would like to see it higher and the timing of his recent remarks are probably connected to that requirement.

Is the consumer reacting by allowing more spending to take place when faced with higher costs after the delivery of a direct government sponsored cash infusion?

Certainly it would appear that real retail and food sales have stopped dropping and have turned up as government stimulus is delivered. The consumer is using more dollars to buy goods, a directed reflation is unfolding.

Is there anything that Bernanke should be worried about? There is and at An Occasional Letter we monitor a set of relationships that can and do warn of a change in the Dow:

Normally we see that when the Yen drops, the Dow rises and vice versa. Recently though that relationship (as I hinted a few weeks ago) has broken down, with the Yen and the Dow falling together. So what has changed that breaks this relationship and the carry trade?

The dollar. I suspect many are now looking for a sustained rise in the dollar and have begun to position accordingly. The Dow (and Treasuries) may well be suffering from an unwinding of over-extended carry trades. How long could this last for? Here is $/Y on a monthly chart:

What else should Bernanke have on his watch list? He will be monitoring the weak link in the credit system, looking for an orderly recovery:

Will the Fed win through; will it get its re-flation, steeper yield curve and a kick-start to bank lending?

I could give a definitive answer but that's not what An Occasional Letter is about. Right now we do not see banks opening the vaults and losses are still pouring out of the bank/broker sector. We are aware of the big plan and can monitor the same indicators that the Fed is watching but we do not need to tie ourselves to one view or the other, to do so would be to under-estimate the forces involved. With asset deflation effects spilling over into the real economy, with commodities being used as a safe haven / inflation hedge and a US monetary/fiscal policy attempting to defuse any deflationary episode my job is stop you standing in front of the train.

Remember the 25th May Weekly Report? In that article you can find my representation of how I think it's going to play out.

Have a good week and stay off the railway tracks.

First up are some charts. An Occasional Letter From The Collection Agency subscribers get a week ahead call on the Dow, FTSE and Gold as well as the occasional share that I think has some interesting opportunities. They also receive the Weekly Report and every so often, an occasional letter. Not bad for $20 a Quarter considering the rest of the site is free with many useful links and charts. New uses for a rather good proprietary indicator are sought and after some back testing are introduced to the site. This week I want to share the new hourly Dow indicator, which is still experimental but worth a look.

The indicator highlights support and resistance levels that adjust to a median price of the Dow, I use it in conjunction with traditional support and resistance levels and chart patterns. There is also a moving average that I believe helps to pinpoint shorter term trades. I subscribe to the simple rule that support is support and resistance is resistance. They normally do what they are meant to. Occasionally they don't and we can be alert for those possibilities but in the main, we look to play it straight.

How does it work? Simple, we look at the trend. The green line is the median, the neutral point. The blue and red lines are the proprietary indicator levels of support and resistance. The purple lines are traditional support and resistance levels, the thicker the line the more important the level. The Williams % indicator is used to spot divergences between price and the W% to help identify old, "tired" trends. For "scalpers" on the hourly chart, the red MA helps with shorter term changes in trend.

Here is the Dow hourly February - mid April 2008:

As you can see the chart finishes with the hourly price at support (second blue line up from the green median) after an uptrend move of over 200 points. So what happened next? Did support break and the up move reverse or did support allow for a new base for a move higher?

And here is mid April to current:

Looking at the left side of the chart, that 2nd blue line up from the green median was resistance, it broke, became support and the uptrend continued. That blue line then remained support until 30th April, although braver traders who held until the close of the candle may have stayed long. The trade exit at the 30th April would have netted 250+ pts. However, if you played the move looking to exit at the next resistance attempt (close up view):

you would have netted circa 280 pts as the spike up open and move higher petered out the next trading day. Either trade was good.

Why did I highlight this trade instead of the more eye-catching move up from the green median line and traditional support level at 12350ish? Well, firstly it was only a tentative support level at 12350 and secondly it was a basing move that lasted over 2 trading days, the real move up was the opening spike on the 16th, most would have missed it. Taking the long, in an already established uptrend, later in the day on the 16th when resistance was broken is more realistic.

Taking us back to the current price and we have a nice set up, here is a close up:

Our tentative traditional support at 12350-ish (thin purple line) that we saw back in April came into play in early June. Of more interest right now is where the Dow closed on Friday, right at a prop'y indicator support level. My long suffering subscribers will get my thoughts for next week but as you can see we could be in for a very simple to call move.

Remember though, the hourly Dow prop'y indicator is experimental, the daily version is pointing to a different possible scenario.

18 months ago I wrote an article that showed a set up, discovered by Dan Basch, which helped to show when markets are topping. It has served me well over the intervening period. Now another set up has appeared. Dan used an example of the Nikkei to show the set up. Whilst he uses diamond formations in his example, I do not purely because I don't like them. However, the rest of the chart is a beauty. Here is the chart Dan used:

The part I like is the move from the low into the rising wedge, culminating in the bearish block. The numbers are to identify turns, not Elliott waves.
Here is a chart of Oil:

Using the almost double bottom at $85 as the start there is an uncanny resemblance to the Nikkei example. If Oil starts to consolidate hereabouts or a bit higher and builds a bearish block and we get a negative divergence on the MACD (the peak at 7 and where the peak for 9 will be) we have a nice trade to play. Put it on your watch list. Downside targets would be $100-105 and possibly $85, approximately. I would wait for this pattern to happen before entering a trade.

We move on and look at the comments made by Dmitry Medvedev at the start of the International Economic Forum in St Petersburg this weekend:

• Russian President Dmitry Medvedev blamed "aggressive" United States policies on Saturday for the global financial crisis and said Moscow's growing economic muscle could be part of the solution.

  "Failure by the biggest financial firms in the world to adequately take risk into account, coupled with the aggressive financial policies of the biggest economy in the world, have led not only to corporate losses," but "Most people on the planet have become poorer." (Reuters)

Medvedev went on to extol the virtues of cash rich Russian companies investing abroad and pushing for Moscow to become a major financial centre. Most interesting though was his continuation of Putin's argument that the Rouble should become a reserve currency. Medvedev added:

• ``economic egoism'' has led to what may be the worst economic contraction since the depression of the 1930s, and placed some of the blame on the U.S. The Russian leader said no single country, even the U.S., can reverse the global economic decline alone, and claimed a role for Russia in finding a solution. ``The disparity between the formal role of the U.S. in the world economic system and its real potential is one of the main reasons for the current crisis,'' Medvedev said in St. Petersburg. ``As strong as the U.S. market is, and as reliable as the U.S. financial system is, they aren't capable of replacing global goods and financial markets.'' (Bloomberg)

He is quite right, even the US at the height of its economic power cannot stop a systemic failure in the financial system; it requires a co-ordinated and inclusive approach, something the US finds difficult to do. Interestingly Medvedev appears to be doing the same as the Federal Reserve, offering help to a beleaguered entity whilst showing what the price of that help would be. The Fed wants more regulation and oversight of Wall St et al. The Russians want a slice of the power that having the world's reserve currency gives a nation.

The timing of this move by Medvedev is interesting too. It's the kind of political offer you want in the open before a problem appears so that you can offer help in an immediate way. That says to me that the Russians expect the situation in the financial system and commodities markets to become worse. Would the US, UK or parts of Europe turn away Russian investment in times of great need?

That's it for this week. Remember volatile markets can be great for trading but they are designed to make most participants poorer. Stay protected.

Welcome to the Weekly Report. This week we look at the end of the western world as we know it. Well okay if not the end then it's the beginning of the end. My interest over the past few weeks has switched from stocks into bonds. Interesting things are happening to bonds and we should take note. We round off this week with a look at the Dow and a new indicator.

First up though is gold. Has CA become a gold bug? Well no, for me gold is a commodity that has its intrinsic worth tied to inflationary expectations, as someone expecting a deflationary end to the western world you can imagine I use gold, rather than hold gold. What got me thinking more about gold was a recent email I received:

• Hi Mick,

  When you have a moment, will you be kind enough to let me know what is the best asset or currency to have on hand during deflation?

  Sue
  

Sue raises a very good point at just the right moment and as I cogitated upon a reply I realized it was much more complicated matter than you would think. Fortunately I have been following a strategy that takes into account the possibility of deflation. Here is my reply:

• Good question Sue!

  Firstly, what follows is my opinion on my approach, its not intended as advice to anyone.

  I hold gold (physical) and I have been hedged with a short from just under $1000, this is a twofold strategy. It protects the fiat profit on the physical and allows me to realise that profit when I buy back the short at lower levels. It also saves inflated, cheaper dollars now to realise them in profit as more expensive dollars later. I treat dollars like an asset, no different from oil for instance, the price of dollars will fluctuate.

  In a deflation you want to find fiat currencies that have a low debt service for its Nation issuer, eg, Swiss franc. Highly indebted sovereign states will struggle with higher nominal yield payments on debt.

  In the not too distant future, there may well be an opportunity to lock in high yields in top rated debt.
  

Yes, I have seen that short hit $848 and bounce to the $930s and not taken a profit. This isn't a trade for the short term. Either it gets closed if gold rises back to the short breakeven area or when I decide that the end of the western world as we know it has happened. I suspect the "or" maybe more difficult to judge than the "if".

Why do I like the Swiss franc? Compare these two charts:

What then has me bearish on gold and reinforces my deflationary outlook? The following chart is from a member of Livecharts who has spotted a rather delicious set up. Here is Sarah's chart:

With thanks to Sarah and Stockindextiming.com

So that was the situation back in late April, let's have a look at a daily gold chart up to the present:

I have concentrated more on the end of the pattern shown by the horizontal lines drawn on the first chart and the support/resistance area at $885. What do we see; ahhh yes in the 1929/87 examples there is a rise in price after the initial break through support. Gold did the same; it broke through $885 at the end of April and early May and then bounced from $848, rose to a minor top around $936 and then took out $885 again. Looking at the closing price, you can see why I consider gold to be the top priority this week. (The arrows are for subscribers, they pinpoint support and resistance in advance of the event, last week I highlighted the moving average as the support area to watch).

Now comparing patterns from differing instruments in different times (I happen to like fractals) is not an exact science, the relationship can break down at any moment. Right now I would need to see gold close above $885 and preferably above the MA at $902 on a weekly basis before thinking about a bullish outlook. I see no reason to change my current position, if the fractal pattern continues then gold has a long way down to go and the descent is imminent.

Do I have any other data that helps support my bearish gold stance? Here is a chart that you may recognise from earlier articles:

This a monthly dollar/yen chart, are we going to attempt a visit to the upper trend line?

Moving on to bonds, there are some important levels in play at the moment. First up is the yield curve and it is signalling a problem for Banks. To re-ignite lending, Banks need a steep yield curve, borrowing low at the short end and lending high at the long end. It's not going to script:

With thanks to Stockcharts.com, click on the image to visit the dynamic yield curve.

Rates continue to rise but the curve is flattening as the long end attempts to remain anchored. If the Federal Reserve wants to see its plans come to fruition, the curve must re-steepen to encourage Banks to lend. From a technical point of view, we have 2 important levels ahead of us:

A break above 4.43% would open the door to attempts at 5.2%. The 10yr yield looks flaccid when compared to the 20yr, which is ahead of the game:

A move above 4.81% could see new highs. Right now interest rates may be about to move higher across the board, the big test is whether the market lets the long end go on a steepening move. As it stands it's a good point for traders and investors to watch and wait for developments in anticipation of a good trade.

Finally, a look at the Dow, this is an hourly chart using a proprietary indicator (the "bands") and showing the horizontal support/resistance levels at 13130 area and 12740 area:

I cannot view the Dow as remotely bullish until the 12740 is breached to the upside. Even then I would want 13130 to be taken out before thinking we could go higher. A move above 12810 (the median "band") would also offer some promise.

The hourly chart is still at the experimental stage. The indicator is used to highlight potential support and resistance.

That's it for this week. Keep a close eye on the longer term trends.

Welcome to the Weekly Report. Due to family illness, this week's letter will be shorter than usual. This week we re-visit the scenario used for the Occasional Letter series as another milestone is passed.

The Scenario:

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

I wrote the above scenario many years ago. My only regret was that I didn't write it more clearly. It was not written as a linear listing of events, it was meant to show an interactive series of events that run parallel to each other. These events overlap, some are a reaction to others but they all move in the same direction. Let me attempt to show you how I "see" this. I am going to quantify the various factors that make the scenario and measure them on a time line. This will give us a visual representation of the various strands. The relationships on the chart are important, not the numerical value.

Don't worry about whether you think EZ money should be a higher value, that's not what I want you to see. Instead think of the trends and how they relate to each other. The diagram displays the historical as well as the future trend. Right now I see a post bubble, low interest rate environment, where EZ money is disappearing as credit contracts. Funds have poured into commodities as unstable stock markets and topped out bond markets make traditional investment havens unattractive. Meanwhile money, real paper and coinage, continues to slow and contract as the real economy suffers.

Which brings us to the milestone. Current interest rates are not reflective of current circumstances. Think of the attractiveness of assets and their returns. Commodities are currently appreciating in capital, prices are rising but they do not pay a dividend or a yield. We have been here before and not that long ago, last time it was tenuous promises of dot.com companies, this time its hard and soft commodities. The "attractiveness" measure of assets is about to change.

The IMF issued a downbeat report on the UK economy earlier this week. Whilst it is country specific, its relevance to other similar economies cannot be ignored, especially the US. (The latest IMF report on the US - http://www.imf.org/external/pubs/ft/scr/2007/cr07264.pdf)

Here are the paragraphs that interested me:

• 7. Three elements can help respond to these broader challenges.

  8. First, continued moderation in nominal earnings growth is essential. If secured even in the face of relative price changes, monetary adjustment and associated sterling depreciation may reduce risks to output, the external balance, and employment without compromising the nominal anchor. But if not, monetary flexibility to address these concerns will be diminished.

  9. The risks to nominal wages appear balanced. So far, nominal remuneration has held steady, encouraged by the flexibility of labor market institutions and public sector pay restraint. But key wage settlements remain outstanding, and tolerance for continued low real earnings growth is uncertain.

  10. In this context, we see no scope for further near-term monetary easing absent assurances of continued wage moderation, fiscal policy that is tighter than planned, or signs that house price and credit developments are significantly curbing domestic demand, relative to our central case projection for continued growth. Indeed, given the risks to the nominal anchor, monetary policy should stand ready to tighten at the earliest clear signs of emergent nominal wage inflation.

  11. Second, as the commodity and consequent relative price shocks have a permanent element, the appropriate focus of the policy response is fiscal. In this context, budget consolidation should rebalance demand-away from domestic in favor of external-to the benefit of the current account balance, activity, and employment.

  13. Third, efforts to stabilize financial markets remain essential. This will not only reduce lagged effects on credit flows from past strains, but will reduce remaining tail risks and support more efficient pricing of risk in future.

There is no respite for the UK consumer. If inflation pressures remain high (commodity pricing) and sentiment amongst workers changes to demand higher compensation then both the taxation burden and interest rates should rise. Even if prices moderate, current levels of taxation and rates are judged appropriate. It is the effective pricing of risk that should draw your attention. Risk has not gone away, indeed without centralist intervention risk pricing should be at much higher levels today. The natural pressure on interest rate direction is for higher levels of return, not lower.

In effect the IMF wants to see a relatively high rate of interest and a sustained taxation burden to force a slowing of consumer and business demand at a domestic level whilst hoping that a depreciation of Sterling occurs, allowing an export oriented growth regime to be created. Any attempt to increase worker compensation should be denied and a reduction of domestically orientated employment will help curb wage demands.

For those readers who are familiar with the UK situation the direction of the IMF report comes as no surprise. The UK Government and the Bank of England have been following such a path for sometime. The IMF recognises this and in a week that has seen Prime Minister Brown under severe pressure, they silently slipped a dagger into his back, albeit quietly and "buried beneath other news"

• 19. First, building on the success of the recent Comprehensive Spending Review (CSR) in slowing the pace of expenditure growth, there are advantages to reversing the relative status of the golden rule and the medium-term spending limits........The implied change in the status of the golden rule would end concern with adjustments to its definitions, which despite having had only modest implications for fiscal space, have eroded confidence in the rule. It would also reflect the success of the broader policy frameworks, which have underpinned reduced economic volatility thereby diminishing the need to define fiscal or other rules "across the cycle."

The golden rule is central to PM Brown's arguments about his fiscal responsibility and his fitness to lead during difficult times. He relied upon the golden rule heavily whilst chancellor. It is apparent that he is hoping to move, unnoticed, away from such constraints. With PM Brown and his party losing heavily in a recent election to a vacant seat and calls for PM Brown to change direction, the IMF assurances may become unhinged and a large increase to their downside risks may occur. PM Brown may well be unable to withstand the pressure of calls for higher wage compensation and a decrease in taxation. This would lead to increased pressure on the Bank of England to raise rates to combat inflation, even if the Government attempted to discourage such a move. Such a scenario could play out over the next few months, making assets such as gilts attractive in an accumulative purchasing strategy.

With US policies of direct cash infusions (tax rebates) and current low interest rates the order of the day, we can see that the IMF advice has already been ignored by the Federal Reserve and the US Government. Unless domestic recessionary forces become stronger, adversely affecting employment and degrading the ability of workers to gain higher wages, interest rates in the US are going to rise, sooner rather than later. Either way, the scenario for US consumers looks poor, they face either higher prices and interest rates or higher prices and a loss of wages through unemployment or inflation. Whichever path is followed, the US consumer faces a loss of disposable income, a direct deflation of cash. With a continued and increasing constraint on credit availability consumers are left with no choice but to curtail spending. Again like the UK, an accumulative purchase strategy of US Bonds as rates rise would be attractive.

A reduction in credit, real money and inflation whilst interest rates are rising would make the prospect of "stair stepping" into Bonds to achieve higher nominal and real returns much more attractive than holding long positions in commodities.

The timing of such a move, a change in the attractiveness of assets, may be closer than many realise.

Have a good week.

Welcome to the weekly report. This week we look at inflation and deflation, the Dow, gold and FTSE but start with a look at a recent speech by William C. Dudley who is the executive vice president of the Markets Group at the Federal Reserve Bank of New York. He is also the manager of the System Open Market Account for the Federal Open Market Committee. The Markets Group oversees domestic open market and foreign exchange trading operations and the provisions of account services to foreign central banks.

If you want to know the effect of the Fed facilities on the markets, Mr Dudley is the man to ask. In a follow up to a speech he gave back in October '07, Mr D looked at the effects that the various Fed facilities had on the LIBOR/OIS spread and whether the facilities had done the job they were designed to do, i.e. introduce liquidity for assets. The speech covers a lot that my readers already know so I'll reproduce the salient paragraphs and charts and then add my comments afterwards.
This is the problem as W C Dudley sees it:

• "Let me first define the underlying problem. The diagnosis is important both in influencing the design of the liquidity tools and in assessing how they are likely to influence market conditions.

  As I see it, this period of market turmoil has been driven mainly by two developments. First, there has been significant reintermediation of financial flows back through the commercial banking system. The collapse of large parts of the structured finance market means that banks can no longer securitize many types of loans and other assets. Also, banks have found that off-balance-sheet exposures-such as structured investment vehicles (SIVs) or backstop lines of credit that are now being drawn upon-are adding to the demands on their balance sheets.

  Second, deleveraging has occurred throughout the financial system, driven by two fundamental shifts in perception. On one side, actual risks-due to changes in the macroeconomic outlook, an increase in price volatility, and a reduction in liquidity-and perceptions about risks-due to the potential consequences of this risk for highly leveraged institutions and structures-have shifted. Many assets are now viewed as having more credit risk, price risk, and/or illiquidity risk than earlier anticipated. Leverage is being reduced in response to this increase in risk.

  On the other side, the balance sheet pressures on banks have caused them to pull back in terms of their willingness to finance positions held by non-bank financial intermediaries. Thus, some of the deleveraging is forced, rather than voluntary."

Mr Dudley then goes on to explain the reinforcing (viscous circle) that has occurred because of these pressures, culminating in the Bear Stearns episode. After looking at the effects of intermediation and deleveraging, the LIBOR cheating and subsequent reset higher, FX swap prices and increased counter party risk W C Dudley still feels these areas may explain some but not all of the reasoning behind the funding pressures.

So Mr Dudley digs a little deeper (they may move slowly at the Fed but the analysis can be good) and pinpoints what he sees as the real problem:

• "So what has been driving the recent widening in term funding spreads? In my view, the rise in funding pressures is mainly the consequence of increased balance sheet pressure on banks. This balance sheet pressure is an important consequence of the reinter - mediation process. Although banks have raised a lot of capital, this capital raising has only recently caught up with the offsetting mark-to-market losses and the increase in loan loss provisions. At the same time, the capital ratios that senior bank managements are targeting may have risen as the macroeconomic outlook has deteriorated and funding pressures have increased.

  The argument that balance sheet pressure is the main driver behind the recent rise in term funding spreads is supported by what has been happening to the relationship between other asset prices-especially the comparison of yields for those assets that have to be held on the balance sheet versus those that can be easily sold or securitized."
  

Here comes the good bit, central to Mr Dudley's speech:

• "Why is this noteworthy? Jumbo mortgages can no longer be securitized, the market is closed. Thus, if banks originate such mortgages, they have to be willing to hold them on their balance sheets. In contrast, conforming mortgages can be sold to Fannie Mae or Freddie Mac. Because the credit risk of jumbo mortgages is likely to be comparable to the credit risk of conforming mortgages, the increase in the spread between these two assets is likely to mainly reflect an increase in the shadow price of bank balance sheet capacity.

  If this is true, then the same balance sheet capacity issue is likely to be an important factor behind the widening in term funding spreads. After all, a bank has a choice. It can use its scarce balance sheet capacity to fund a jumbo mortgage or to make a 3-month term loan to another bank.

  If balance sheet capacity is the main driver of the widening in spreads, this suggests that there are limits to what the Federal Reserve can accomplish in terms of narrowing such funding spreads. After all, the Fed's actions cannot create bank capital or ease balance sheet constraints materially. "
  

Now for my readers, myself and a few other writers and bloggers out there, most of the above is "old news". We recognised the effect that a re-pricing of assets would have on bank balance sheets, especially when Basel 2 kicked in quite some time ago. Whether Basel 2 caused the re-pricing or not is now mute (in the US B2 only applies to the top 10 international banks). It happened and we have to live with it.

By concentrating on bank balance sheets and the repairs required to capital ratios, investors have an important anchor point for fundamental analysis. For instance (and this is why you love me) in the FTSE 100 we have a large bank sector which has and is being battered, except for HSBC, which despite huge write offs still sees its share price supported and rising. A quick glance at the global business models of the FTSE 100 banks shows why and is pinpointed by Mr Dudley in his speech:

• "The overnight index swap rate is the expected effective federal funds rate over the stated maturity of the swap. As shown in the two exhibits on page two, this pressure on term funding rates has occurred in the United States, Euroland, and the United Kingdom. It is a global phenomenon."
  

Oh go on then, here is the HSBC chart, TA followers will like it:

Back to Mr Dudley who after identifying what he sees as the central issue, bank balance sheets, then goes on to explain the reason d'être of the fed facilities:

• "In essence, the Federal Reserve's willingness to provide liquidity against less liquid collateral allows the reintermediation and deleveraging process to proceed in an orderly way, which reduces the damage to weaker counterparties and funding structures. One can think of the Federal Reserve's actions as smoothing and extending the adjustment process-not preventing it-so that the adjustment causes less damage to the financial system and less pernicious macroeconomic consequences."
  

The Fed has morphed what should have been a very short, sharp and hugely disorderly event into a controllable, slow, deflation of the banking and financial system. The longer term impact of this should not be under-estimated. The Fed took a big risk stepping up to the plate and hitting home runs, there will be a form of payback expected from the financial sector. The effects will also be felt for some considerable time in the real economy too. Credit availability, in all forms, may well remain tight for much longer than anticipated.

To me this is good news. The removal of a credit reliant economy, where consumers overspend against future earnings and business mal-invests using loans to attempt to increase profitability is welcomed.

An Austrian School economic model may well be imposed upon the US, not through a political will but through the exigencies of the outcome of the credit crisis. In other words, the failure of the current Keynesian/Monetarist model (and it has failed, having a part of an economic theory that allows for centralist intervention doesn't mean that it works) will inevitably lead to a proper pricing model of worth, risk and production.

No decision will be made to actively seek such an approach, it will occur as required by circumstances over a period of time. We will have to get used to banks and financials not being the front runners in the future, the new go-getters will be those companies that using savings from profitable enterprises to re-invest and expand.

Many wonder what the next "big thing" might be, the next dot.com, the next housing or commodity explosion. I don't see it that way, I think the next big thing will be well run businesses that operate transparently and use profits to invest. They will carry little or no debt and will not require it to continue operations. In the current and future environment of expensive and scarce credit availability, these companies will have a competitive advantage that will be difficult to overcome. The actual line of business, what is produced, isn't important, what is important is how the profit is achieved.

In such an environment, deflation or the increasing appreciation of fiat currency is not to be feared, except by those reliant on credit. With the banks and financials being led by the hand toward responsible lending, coupled with tighter standards and low or no leverage, the future expansion of credit will become much more difficult and probably politically unacceptable.

The future benefits of a system based on true pricing and worth, located in the US with all its resources would be a formidable economic power. Is the US brave enough to take the first step?

As usual Gold, Dow and FTSE trend updates are available on the Trend Indicators page.

Have a good week.

Welcome to the Weekly Report. This week we look at Gordon Brown the UK Prime Minister, US and UK mortgage markets and the US consumer.

Before we start, a friend sent me an email that I would like to show you. I'm sure he would appreciate the readers help:

• Hi to all my friends

  Please say a prayer for my wife Sam as she had a heart attack on thursday, I nearly lost her on that day, she is now in the Royal Brompton hospital in London and it looks like she is going to have a pacemaker fitted.

  Please give her a positive thought that all will be well as I believe in the power of prayer and positive thought.

  Thanks

  David
  

In the early nineties the UK suffered a housing bust that lasted for at least 7 years, possibly longer if you measure it until the bottom of the cycle. Indeed, I well remember selling a property in London in 2000 that the Estate Agent was pessimistic about, needless to say the price eventually went much higher than their estimate. They didn't get the sale. From 2000 to 2006 the property market could be viewed as benign, prices went up (and up) whilst affordability from a debt servicing point of view increased. This coupled with loose lending standards (125% mortgages, mortgage limits set at multiples of 5 or 6 times gross earnings) encouraged a buying spree.

However, when you view the figures of mortgage possession actions in County Courts, you can see the clear "suckers rally" that has now turned sour:

Possession claims, orders and repossessions have risen markedly since 2004 and show signs of acceleration. Notice the Q1 '08 growth when compared to Q1 '06 and '07, that's not a good indicator of the future prospects of UK housing. Here is a chart that shows the previous peak in possession activity, the retracement to a low and now the new rise:

I know it's a dangerous game to try and extrapolate a future trend from one figure but let me be conservative in this. If the rest of '08 shows no further acceleration of possession action, then the final figure will be around 161k. For the final figure to be back inside the 2000-2004 good times then only a 20-30k increase over the next 3 quarters is allowed. I doubt very much the latter is going to happen, personally I see 2008 as going on record as the 2nd worst year for home repossessions. There is an extremely strong possibility that it may try and take out the figures for 1991. Why do I feel this is possible?

It is down to the difference between the US Govt/Fed reaction to the mortgage market implosion and that of the UK powers that be.

The US has attempted to loosen regulation, expand the book of the GSE's, lowering capital ratio requirements, slashed rates and actively pursued a dialogue with lending banks and institutions. The icing on the cake was the direct interference with the credit system, allowing credit markets to function using the Feds assets.

The UK has a lending facility that is expensive and restrictive, rates have stayed high, lending banks have ignored pleas from the Government and mortgage products have disappeared in their 1000's and the remaining products have new, tighter standards. The UK Governments response is shoddy at best, negligent at worse. This is the best they can offer:

• Chancellor of the Exchequer Alistair Darling yesterday met mortgage lenders to discuss lending conditions. Caroline Flint today said that the government will also ask lenders to improve the advice it offers customers seeking to refinance debts. ``For the minority of owners who may need support and advice now, we want to ensure it is there for them in the right place and at the right time''

In other words, they are doing nothing. Notice it is the lenders who are asked to offer better advice. Now you know me, I hate intervention in free markets and believe that bubbles of any nature would not form if the participants understood that there was no safety net. However, in the "real" world, away from my ideals, there is interference and intervention that is causing participants to rely on a safety net.

The problem for the UK is the flawed character that is Gordon Brown. Here is a man who in the face of a defeat that outranked any other that happened to the Labour party in 50 years, struggled to see what he had done wrong. Eventually he allowed the rise in taxation of the poor, that he instigated as Chancellor of the Exchequer, to be blamed but only after his party membership told him it was going to happen with or without his blessing. Even when Brown admitted it had been a "bad night" for Labour, his remedy was to "listen and lead". Well we can all do that, it's not hard to listen to someone and then blindly carry on as before.

Has the increased tax burden been reversed? No, Brown will try and divert attention away from such a move and talk about compensation from other schemes that will help "most".

This exposes the first flaw. He is unable to admit that any action he has taken (even when circumstances change) is wrong. He will attempt to blame others or deflect attention by promising "action" that in reality amounts to no more than "jawboning".

The second flaw is much more serious. Brown came to power after ousting Mr Blair, he did so without meaningful opposition or a public vote. He had been manoeuvring for well over 10 years to attain the Premiership and eventually succeeded. What I never understood was his timing. Brown is not unintelligent; he had an iron grip on all matters economic and yet he allowed himself to take over the leadership in a short burst of activity, regardless of the global economic circumstances:

• May 10, 2007

  CHANGE AT DOWNING STREET

  Blair Announces Plan to Step Down

  After 10 years in the post, Tony Blair is resigning as prime minister. Dogged by popular backlash from the war in Iraq, the outgoing leader hopes history will focus more on his achievements.

Brown took over 6 weeks later. Were there indications of what was to come? Certainly by the 10th May '07 many of the bloggers and writers were calling for a credit crunch, along with one or two more far sighted analysts and a list of credit related events was piling up:

• 3 May

  GM finance unit loses heavily on sub-prime mortgages

  UBS closes its US sub-prime lending arm, Dillon Read Capital Management.

  17 April

  US government-backed lenders try to tackle sub-prime crisis

  2 April

  US home sales fall sharply

  New Century Financial filed for Chapter 11 bankruptcy protection after it was forced by its backers to repurchase billions of dollars worth of bad loans. The company said it would have to cut 3,200 jobs, more than half of its workforce, as a result of the move.

  16 March

  US-based sub-prime firm Accredited Home Lenders Holding said it would sell $2.7bn of its sub-prime loan book - at a heavy discount - in order to generate some cash for its business.

  13 March

  Wall Street hit by sub-prime fears

  12 March

  Shares in New Century Financial, one of the biggest sub-prime lenders in the US, were suspended amid fears it might be heading for bankruptcy.

  8 March

  Biggest US house builder DR Horton warns of huge losses from sub-prime fall-out.

  22 February

  HSBC fires head of its US mortgage lending business as losses reach $10.5bn .

Yep, I think there was enough going on in the US to have made Brown stop and think about the possible consequences. But he didn't stop and think, he allowed his normally cautious approach to be bypassed. His desperate need for power over-ruled every other consideration. I can only surmise it was either to move out of the Chancellor slot before the proverbial hit the fan, or his ambition blinded him to what was coming.

Either way, Brown is an egotistical, self centered individual who despite his protestations is clearly concerned with his image and place in history. His inability to see beyond his own intellect and a belief in his own infallibility will allow him to make decisions that will clearly not be in the public (the peoples) interest. Brown will continue to blame the "global situation" rather than acknowledge that his spending and borrowing plans, the allowing of loose lending standards and the massive over-supply of money he presided over as Chancellor has set the UK economy on a path that may take a decade to recover from.

It his flawed character that will prevent him from taking the kind of concerted action that is required if you wish to keep the current financial system viable. To take such measures would undermine his claim to have been the best Chancellor the UK ever had and destroy his reputation. So, instead of committing political suicide he will allow the situation to get worse, rejecting calls to change policy. He will damn the people by inaction.

Still, at least the public now see him for what he is, judging by the recent local elections and the polls. The trouble is, by the time Brown goes to the electorate and gets the boot, it may well be far too late.

The US consumer is now in deep trouble, below is a chart showing the change in US Personal Consumption, from Bloomberg:

So far the consumer has relied on credit to make up the shortfall on income. Credit (red line, chart below) continues to reach historically high levels but it would appear it is not to bolster sales (blue line). I hope I am wrong but are consumers using credit cards to supplement mortgage payments?

Either way, consumers in the US are retrenching at some pace and I doubt the $600 tax rebate is going to do much other than offset gasoline price hikes.

>

For those of you who read my latest Occasional Letter "The Bernanke Conundrum" you will have seen why I believe that for consumer and business, it is different this time. I do not believe that the US (and UK) can avoid a period of deflationary recession, at a minimum, in the face of a full on credit contraction.

Without meaning to influence your trading or investing (you must make your own minds up) I am extremely cautious right now. I expect the situation to deteriorate in H2 '08.

That's it for this week.

Welcome to the Weekly Report. This week we look at moral hazard and I show you how it's about to unleash forces that no Central Bank or Government can control and we look at next weeks trend indicators and targets.

I have spoken about moral hazard before, especially in relation to the current actions carried out by the Federal Reserve and the Bank of England after the bailouts of Bear Stearns and Northern Rock. To avoid moral hazard arising strict controls have to be placed upon the facilities that are created and the use of the assets supplied from those facilities. A failure to control the results of centralist intervention will encourage the very behaviour that caused the original problem.

Let me be blunt. There is no risk to the financial sector that is so great that could justify invoking a moral hazard. If a bunch of banks and investment houses collapsed under the strain of unserviceable debt or losses so great that creditors required compensation, so be it. The pain would be enormous and the recession deep but the US economy and importantly the US financial sector would re-emerge stronger, leaner and fitter than at any time since WW2.

As we know such an event will not be allowed to happen, the Fed and the US Govt are working together to ensure that credit markets at least allow maturing debt to be rolled over, giving time to the banks and investment houses to rebuild their capital reserves. It is a 2 pronged attack, the Fed keeps the banks functioning and the US Govt drops money directly onto consumers in an effort to encourage spending or re-finance mortgages that have become too burdensome. These measures have no time limit, they can be repeated and increased until the day occurs when banks tell the regulators "all is well".

The groundwork for an episode of moral hazard is laid out but not yet constructed as long as the facilities are controlled and the assets applied to the task at hand.

What would initiate construction? The loosening of control, the allowance of a facility to be used for a purpose other than its original intention would see the foundations poured. That loosening has now occurred.

• Release Date: May 2, 2008

  For immediate release

  Central banks have continued to work together and to consult regularly on liquidity conditions in financial markets. In view of the persistent liquidity pressures in some term funding markets, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing an expansion of their liquidity measures.

  Federal Reserve Actions

  The Federal Reserve announced today an increase in the amounts auctioned to eligible depository institutions under its biweekly Term Auction Facility (TAF) from $50 billion to $75 billion, beginning with the auction on May 5. This increase will bring the amounts outstanding under the TAF to $150 billion.

  In conjunction with the increase in the size of the TAF, the Federal Open Market Committee has authorized further increases in its existing temporary reciprocal currency arrangements with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will now provide dollars in amounts of up to $50 billion and $12 billion to the ECB and the SNB, respectively, representing increases of $20 billion and $6 billion. The FOMC extended the term of these reciprocal currency arrangements through January 30, 2009.

  In addition, the Federal Open Market Committee authorized an expansion of the collateral that can be pledged in the Federal Reserve's Schedule 2 Term Securities Lending Facility (TSLF) auctions. Primary dealers may now pledge AAA/Aaa-rated asset-backed securities, in addition to already eligible residential- and commercial-mortgage-backed securities and agency collateralized mortgage obligations, beginning with the Schedule 2 TSLF auction to be announced on May 7, 2008, and to settle on May 9, 2008. The wider pool of collateral should promote improved financing conditions in a broader range of financial markets. Treasury securities, agency securities, and agency mortgage-backed securities continue to be eligible as collateral in Schedule 1 TSLF auctions.

The expansion of the Term Auction Facility comes as no surprise, it has been stepped up since its inception and will probably increase further. However the inevitable reaction to the Bear Stearns bailout has now occurred. The Term Securities Lending Facility has been expanded to allow an increase of lower rated asset backed debt beyond commercial and residential mortgage backed debt.

A reminder:

• The Term Securities Lending Facility is a 28-day lending facility that offers Treasury general collateral to the Federal Reserve Bank of New York's primary dealers in exchange for other program-eligible collateral. It is intended to promote liquidity in the financing markets for Treasury and other collateral and thus foster the functioning of financial markets more generally.

  What are the differences between the TSLF and other Federal Reserve operations, like the TAF and term repo operations? The Term Auction Facility ("TAF") offers term funding to depository institutions via a bi-weekly competitive auction. In contrast, the TSLF will offer Treasury GC to the FRBNY's primary dealers in exchange for other program-eligible collateral. The FRBNY term repo operations are designed to temporarily add reserves to the banking system via term repos with the primary dealers. These agreements are cash-for-bond agreements and have an impact on the aggregate level of reserves available in the banking system. The bond-for-bond lending of the TSLF, however, will have no impact on reserve levels.

Quite right too, the swapping of assets on a 1 to 1 basis if they had equal price would not affect reserve levels. Ahh you see the hole in that argument too? In fact there are 2 holes, firstly the assets swapped are not equally priced, "program eligible collateral" is only swapped because it is useless. With no one willing to accept it as collateral on lending there is no choice but to use the TSLF. In other words assets that should be priced at zero (thus lowering reserves) are swapped for fully priced assets. Only by refusing to mark to market does the Fed assertion of no increase in reserves ring true. Secondly it is this refusal to mark to market, allowing the TSLF to operate as a Conduit /SIV where toxic debt is p