The Secrets of Liquidity

June 26 2010

Result of the end of fed pumping up the economy,Markets torn by zero interest rates, The finances of many states now dire, greater risks for recession and depression, the folly of bond yields, Baltic Dry Index drying up, more COLA for the folks, contracting out an entire city, Hardest Hit fund, Goldman Sachs was not alone, destroying markets

Many investors wonder how are markets able to propel themselves back and forth as they do. How do corrections turn into rallies? The secret is liquidity and the question is where does it come from?

As you know the Fed up until 14 months ago increased what once was called M3 by 15% annually. Foreign major central banks did the same cutting back a couple of months sooner than the Fed. The Fed increased M3 for 5-1/2 years and the other central banks for about four years. Starting four years ago all currencies started falling versus gold. The US dollar started about ten years ago.

Contrary to what government officially has to say about inflation for the past 18 months the sources of liquidity, fiscal money creation by the debt route by the current administration has been $2.2 trillion. The Fed has added $1.2 trillion over that period, but we do not believe their figures for a moment. We believe the number is closer to $1.8 trillion. That is only for the purchase of MBS/CDOs from banks, Wall Street, insurance companies and other corporations. Then we have at least $500 billion in swap arrangements. Those funds were supposedly re-exchanged five months ago. Since then there has been another swap, but we cannot find out what the numbers are. Then there are zero interest rates, which force investors to seek more speculative returns. As an example, funds in money market funds have fallen about $1 trillion over the last 18 months. That is why bonds are at highs and the market can rally. Then there is the adding of liquidity by the Fed via the repo market. Finally, there has been the re-leveraging of banks, or at least the maintaining of 40 to one leverage, and the re-leveraging of corporate balance sheets, sovereign wealth funds and hedge funds, although the numbers are tame versus two years ago. There you have it. The foregoing on a net basis is larger than what existed at the beginning of the credit crisis almost three years ago. New liquidity has been created to replace that which was lost. As a result gold and silver have appreciated in a big way over that period. We see no proclivity to end this massive onslaught. In spite of official figures real inflation is some 7% and that is why currencies keep losing value against gold, which is the only barometer to measure the real devaluation of currencies as a result of monetary and fiscal profligacy.

Markets are torn by near zero interest rates and risk aversion. A trillion have left money market funds over the past 16 months. Some have gone into bonds, junk bonds and into the market. You cannot have it both ways. Bonds cannot go higher and the market is very dangerous, especially with three quarters coming up with passable to bad results. Then there is the possibility of tax increases next year to accompany 19 new taxes in the Medical Reform package. There is also the possible passage of Cap & Trade, which would double gas prices, illegal alien amnesty and government taxing or taking over your retirement plans. These issues are why it is so important to replace almost all the incumbents in November. Not to be treated lightly is the problems of sovereign debt. Not only for those 20 countries on the edge of insolvency, but for those who are owed the debt. There is an excellent chance 5 to 7 countries may leave the euro. The euro may then fade and the other 10 euro zone members may go back to their original currencies. It is any wonder gold is hitting new highs and silver is soon to follow. Gold is not rising to inflation and anticipated inflation, but because of unserviceable deteriorating debt worldwide. You cannot wait for the next crisis – you have to anticipate it. You have to be ahead of the curve and the crowd. Does anyone really believe bailouts and future bailouts and stimulus will solve anything? They haven’t up to now and they won’t in the future. They only make matters worse. What kind of insanity is it to have the Fed buy $1.2 trillion, that they admit too, of toxic MBS and 80% of Treasury issuance, with money created out of thin air? Small and medium-sized business cannot expand and hire new people. They supply 70% of all jobs. Government should be cutting taxes, not expanding them. They should be cutting costs and employees by 30% for starters.

Zero interest rates may fatten the profits of major manufacturers and transnational conglomerates, but it does little for anyone else, except Wall Street and banking. Interest rates on credit cards have risen, not fallen as banks fatten their bottom lines at the expense of the populace. That is why retail sales have fallen over the past two months and probably will continue to do so. A battle wages over M3. Some say it is negative, some say it is in double digits. We will certainly find out shortly. The housing stimulus and credit is now over and prices are falling. Unemployment is rising and risk taking is falling. Now that the dollar has had a large appreciation there is ample reason to believe it could well have a sharp correction. Those in the carry trades know that sovereign debt has a much greater degree of risk than in the past. That means more caution and less liquidity.

On the state level the financial situation is dire. Illinois sold $300 billion in Build America Bonds at a yield 40% higher than Treasuries. Worldwide credit is being bought judiciously. Greece and the other PIIGS have intractable problems, but so do the lenders who bought the toxic waste. As a result the cost of credit default swaps have risen substantially. States and countries in the euro zone cannot print money as the Fed and the ECB can. The market is nervous and it should be. We see major unavoidable trouble ahead, so watch out below.

As we predicted the risk of a double-dip recession /depression have risen substantially over the past two months. Retail, housing and employment are fading and fading fast. It points out that the US economy cannot function positively without massive stimulus. Bank credit is falling as well as individuals pay down debt. In addition exports are starting to fall in the face of a strong dollar, which gives the euro zone participants a 15% price advantage. This is a big price to pay to enrich Wall Street and take down the euro as the dollar’s competitor. We do not believe the dollar can maintain current levels, but damage will continue for another 6 to 12 months. Can you imagine the fallout with the euro at parity? Not only does Europe and the US have trouble, so does China that has to unravel bad bank debt domestically, a market fall that already is off some 25%, but worse they have to deflate a property bubble that will be very painful. De-leveraging for the US, Europe, China and Japan has really just begun and this is why a year or two from now there will be another meeting like the Smithsonian in the early 1970s, the Plaza Accord of 1985 and the Lourve Accord of 1987, where everyone will devalue, revalue, and default. An Illuminist jubilee. That could be triggered by a bond market collapse. A market that has been in a bull market for 29 years. Timing of events is very difficult. We could be off by one to five years. The point is bad – things are on the way, so prepare yourself.

The economy is beset with slowing retail sales, a plunging housing sector and falling credit usage. You might call this individual austerity. Consumer sentiment is consistent with recession. Job creation is negative as are loans to small and medium-sized businesses that create 70% of the jobs. The dollar’s strength is wreaking havoc for US exports, which had been improving.

Greece and Spain are in the soup prominently followed closely in the euro zone by Portugal, Ireland and Italy. China has seen a 9-month 25% fall in their stock market and they are facing a collapse in credit and in real estate.

We no longer consider the oil spill a major factor. It can be solved and turned off any time the Illuminists want to do so.

Politically, Israel has finally gone a step too far and Turkey finally realizes that the EU is never going to accept them due to religious reasons. Turkey is now in the Muslim block. That will be a problem for some of the pro-US-UK Muslim states in the Gulf in the future. Geopolitical risks abound and they are worsening along with sovereign debt problems.

Those who have been reaching for bond yields will eventually pay a very high price. The bond market is no longer a safe place to be, whether it is sovereign foreign bonds, corporates or US paper. The US still has 7% to 8% inflation that isn’t going to go away soon, and in all probability that inflation will soon worsen. Those 10% to 20% returns cannot continue indefinitely, as the US government manipulates the US bond markets. Who would want to buy Treasuries yielding from zero to 3.2% with real inflation of 7%, when you can own gold and silver coins and shares that are appreciating? We know most of the funds entering mutual funds are in bonds. These “boomers