So we're moving. And we're moving people. We're moving.

But where are we moving to? It looks like another mini-bubble. The market seemed prime for a fall in conjunction with a U.S. dollar rally. That could still happen if the U.S. employment report tomorrow is a shocker.

A negative employment will remind everyone that this recovery (if it can properly be called) that is still largely a jobless one. The process of reducing household debt is going to take years and not months if households can't grow their incomes. Real wage growth (adjusted for inflation) is pretty hard to come by in most of the Western world (unless you run a bank).

All this adds up to lower household spending ahead. How much further ahead can stock prices get of corporate profits that may never materialise? We'll see. But valuations are already stretched. Investment advisor Jeremy Grantham reckons fair value on the S&P 500 is around 860 - or 24% lower than yesterday's close at 1,066.

But whether the market breaks up or down here (something Murray has been looking out with his technicals) is up to investors. There is a huge cash position on the sidelines that's still worried to jump back into markets. For the bear to really do his work, he's got to convince these people to get into the market. The Fed is helping by making cash a wasting asset (when you figure in inflation).

Thinking out loud, then, you could make a case for new highs on the market as this cash mountain moves into equities. We saw a chart on Sunday at the opening of the conference hosted by the Gold Standard Institute which showed that the amount of cash on the sidelines exceeded the total market cap of the Wilshire 5,000 (a broad measure of the market value of all U.S. equities).

In layman's terms, it means there is more money in cash right now than there is equity in U.S. companies. Now, there is a very good reason investors are reducing their allocation to stocks. As we've said before, we think the equity premium - what people are willing to pay for stocks - is regressing to the mean. It was so high for so long because corporate cash flows in the second half of the last century benefitted so much from low interest rates and globalisation.

But even if the equity premium is collapsing, it wouldn't take a small change in that cash position to power equities much, much higher. In fact, if the investors holding that cash realise that inflation is a bigger risk than over-valued stocks, they may decide to get out of cash anyway, despite the risk of being in the market.

In any case, we are not suddenly becoming bullish. But we are suddenly thinking that the next phase of this GFC (other than the sovereign debt crisis) is to lure investors back into an equity rally. Whether they are prodded by negative real interest rates on short-term deposits, or lured by equity markets lurching ahead with the backing of the dollar carry trade, well that doesn't really matter.

It could all be moving on up.

What's really worth watching is how the commodities behave in this market. They are moving on up too. This means gold is shedding its image as a risk-aversion asset and becoming something that people want to own. Its allocation in household and institutional portfolios is going up too. And of course, trading cash for things is probably a good trade these days, no matter whose cash you have in your wallet.

We'll have to cut it short today as other deadlines press. But beware. The bear is afoot and he is making mischief. He is doing is devilish best to convince investors that he's hibernating. After all, the November to April period is usually when stocks do their best.

This year has been unusual because, thanks to the Fed, stocks had a great six months during a time when they generally don't do much. It's unnatural you might say. But so are current fiscal and monetary policy, we might say.

We might also say that there is something tawdry about insisting that modern living standards are not negotiable and must be preserved with high public sector debt. In effect, today's policy makers are saying to the future, "Our current well-being and comfort is more important than any debt you may have to repay. We refuse to live within our means because it would inconvenience us to do so. We are too lazy and selfish to recognise our financial mistakes and pay for them. We're going to leave that to you. Suckers!"

It's not very nice. It's not very moral. But it is what it is. And right now, it gives you the chance to prepare your portfolio for the consequences of bad policy (fiscal, monetary, climate...take your pick!) More on all of it next week. Until then!

Dan Denning
for The Daily Reckoning Australia

• Australian Recession in the Works? Ask the Sharemarket
• Negative Equity Becoming the Norm in U.S.A.
• Largest Spike in U.S. Wholesale I/S Since 80s Recession
• Societe General Warns of Freddie Kruger Style Global Recession
• A Possible Holocaust in U.S. Bonds

The kind people at Stratfor sent us a note informing of us such, but granting us permission to use it nonetheless. We sent them a note abjectly apologising for the mistake and thanking them for letting us use it. We've been a bit touchy on that issue ourselves lately. It was a great chart and they made a great point with. So if you're into that kind of macro-political analysis, tool over to the Stratfor website for a look.

So how about the Fed? It's carried on with its wayward monetary policy. And it's carried on with the carry trade by keeping short-term rates low.

In deciding to make hardly any changes to its interest rate policy or even the language from its last statement, the Fed is encouraging traders to resume the dollar carry trade. For now, it looks safe to borrow in low-yielding currencies like the U.S. dollar and invest in higher-yielding assets like the Australian dollar, emerging market stocks, and some bonds.

Go you bubble beauties!

It's hard to believe the Fed is wilfully stupid. The market, through the price of gold, has clearly communicated that it thinks U.S. monetary and fiscal policy is lousy. But rather than defend the U.S. dollar - indeed the integrity of U.S. monetary policy itself - the Fed is choosing to support asset prices through easy credit.

It's also possible that the Fed thinks a weak dollar will reduce America's trade deficit, boost its export competitiveness, and lead to higher employment. We think this is a pipe dream. And we're not talking about a lead pipe. We're talking William Blake-style opium.

But smoke and mirrors aside, does this mean we were wrong about our call last week for the end of the dollar carry trade? If the U.S. dollar index rallied, we expected to see a falling Aussie dollar, falling Aussie stocks, and (even though it's strange) rising U.S. bond prices. All the leveraged risk trades would unwind a bit as dollar shorts covered.

But now what? Is this the all clear for stock indices to make new highs as traders borrow money and plow it into markets to engineer huge returns for the end-of-year statements to investors? The early returns are inconclusive. The Dow was all over the shop, unable to make heads or tails of what the Fed's non-change means. Gold futures made a new nigh, though. And about that...

Gold is very popular lately. It's not returning our calls anymore. And when we see it in public, all it does is glitter and bask in the glow of so many new found admirers. That makes us very nervous, and perhaps a bit hurt. We stood by it all those years when no one loved it.

We like it all the same, although we're just friends now and it's based on gold's ability to preserve the purchasing power of our wealth, not any inherent beauty it may or may not have. But as a practical matter, when you enter a position as the asset is making a new high, you usually get hammered.

That's what happens when you go along with the crowd. It's an axiom that an asset has to make new highs...to make new highs. But it would be nice to buy gold on a correction. Perhaps, though, we are seeing a big shift in market psychology with respect to gold. India's purchase of IMF gold, as we reported yesterday, is just one sign of that shift.

One interesting result from the events of 2009, Murray Dawes mentioned last week, is that gold is decoupling from the U.S. dollar. He sent over the chart below. It shows that two times in the last five years, gold (the black line) has strengthened eve as the U.S. dollar index (the blue line) rallied. And each time after this period of dollar strength, gold then took off to a new move up.

Click to enlarge

Why does that matter? Well, gold usually moves up when the U.S. dollar moves up, and down when the U.S. dollar moves up. For gold to show strength when the dollar is strong shows that gold itself may be breaking out of its correlation to the greenback. And what would that tell you?

For traders, Murray is showing that the movement of the U.S. dollar is what Aussie stocks are keying off of. Thus, knowing where the dollar is headed tells you whether you should be long or short Aussie stocks (as a trader). Murray is sorting which stocks specifically are there for the trading (and in which direction).

But in the bigger picture, gold breaking its negative correlation with the USD would tell you that gold is being remonetised in the world financial system. It would tell you gold is appreciating against nearly all paper currencies. And it would tell you that even if we do see a U.S. dollar rally, you could still new highs in the gold price. You may also see gold break out in a major way in Australian dollars.

Above all, it shows you how valuable it is to own an asset that is not anyone else's liability. We are entering a global sovereign debt crisis because the world's large economies have been engaged in a multi-decade long competition to devalue their currencies. The cheaper your currency is relative to your trading partners, the cheaper your goods are and the higher your exports.

Overly the last fifty years, nearly every country in the world has engaged in some kind of currency manipulation to keep its currency cheap relative to the American dollar. That's because the American economy was the world's largest, and everyone wanted to sell into it.

America's economy is still big, of course. But a lot is changing, yet the currency manipulation has not caught up with the new economy reality. And Western Welfare states are still borrowing money as if emerging market creditors will be happy to fund fundamentally flawed fiscal policies for ever. Not likely. But tomorrow is another day. Until then...

Dan Denning
for The Daily Reckoning Australia

• Prices of Gold in the Top 10 World Currencies
• Gold, the Aussie Dollar, the Greenback and You
• Trouble In Tokyo
• More Money in Cash Right Now Than Equity in U.S. Companies
• Aussie Dollar is Crushing Long-time Rivals Like the Pound and the U.S. Dollar

Something more than meets the eye is going on here. The IMF sale was part of a plan to unload 403.3 tonnes of gold. It's halfway there, and will use the proceeds to fund itself and loans to the developing world (or perhaps Britain and America when they go broke). But what else is going on?

In the past, larges sales of gold - mostly by European central banks - swamped the gold price and kept it in check. The European CBs either felt like they had too much gold doing too little work on the balance sheet. Or, they were manipulating the price of gold down by increasing the supply to the market whenever the gold price began rendering its verdict on global fiscal and monetary policy.

India's central bank is now the proud owner of 557 tonnes of gold. That gives it the tenth largest gold holdings among central banks. But it probably isn't finished. Gold makes up just six percent of India's foreign exchange reserves. There's plenty of room for that to grow.

But don't forget China. China has $2.3 trillion in foreign exchange reserves. But 70% of those - or $1.6 trillion - are in U.S. dollars. It owns over just a 1,000 tonnes of gold. That makes up less than 2% of China's reserves and makes China the seventh largest holder of above ground gold. In fact the gold exchange traded fund (NYSE:GLD) owns more gold than China. France, Italy, the IMF, Germany, and the United States round out top five (from fifth to first).

What this tells you is that China could double (and then double again) its gold reserves and gold would still make up less than 10% of its total forex reserves. Compare that to 66% in Italy, 69% in Germany, 70% in France, and 77% in the U.S., according to official numbers. So what's the big deal?

There will always be a threat that European Central Banks release gold supply on to the market. In fact, European central banks just renewed a five-year agreement (including the IMF) to sell down a maximum of 400 tonnes of gold per year from their holdings. They've agreed to this to disgorge their gold in an orderly fashion.

But it would not surprise us to see the Europeans fail to sell the gold they're allowed to sell under the agreement. Our old desk mate in London, Adrian Ash (now with Bullion Vault) is at the London Bullion Market Association's annual meeting in Edinburgh. Word from UBS analyst John Reade, also at the meeting, is that European Central Bank official Paul Mercier reckons that official holders of gold will, "no longer be net sellers of gold."

As we predicted earlier this year, the European central banks would rather hoard their gold than sell it in a rising market. There may be a price at which they do sell it, in order to pay down sovereign debts. But psychologically, the fact that central banks want to own gold and not sell it is pretty important.

Also, it shows you how the balance of economic power in the world has shifted East. True, the European banks can still dump gold on to the market to drown the price. But between the ETFs, central bank buyers in India and China, and the average man on the street in Beijing, Mumbai, and elsewhere, there are more buyers of gold now than sellers.

And if we were right yesterday that the GFC is slowly morphing into a sovereign debt crisis, then the case for gold is that much stronger. This explains why gold futures were up by nearly 3% overnight and old yeller hit a new high at US$1,084.90.

The only worry? So many hedge fund managers and pundits are singing the same tune: long gold and short U.S. Treasuries. As we mentioned yesterday, the bond bubble could go on much longer than anyone expects. And when so many people agree on something, none of them are usually right. As a contrarian, you'd be worried about becoming a victim right about now.

But yes, in the long term, the end of the Super Cycle in fiat money results in the remonetisation of gold. That is what you're seeing now. And it's probably what you'll see for a few more years. It also ought to benefit other precious metals, and of course, precious metals shares.

Dan Denning
for The Daily Reckoning Australia

• IMF Deems Gold An Idle Asset
• IMF Gold to be Used
• Unlike China, India is Not Willing to Learn from its Mistakes
• Buying Gold, Gossip & Russia’s Tu-160 Bombers
• The Rush to Buy Gold

There are some pretty big issues we left hanging with yesterday's DR. Are the Western Welfare States (the U.S., Japan, and EU nations) really going bankrupt? Things were headed that way before the credit crisis began. If Rogoff and Ferguson are right and the GFC is becoming a sovereign debt crisis, it will worsen an already bad situation.

How bad? We'll show you three of the charts we showed the folks in Canberra on Sunday. This is the condensed version of a forty-five minute presentation. So we'll have to leave out the colour commentary. And we're pleased to offer another contribution from Dr. Steve Kates on how government policy is destroying public wealth.

But first, check out the chart below from the 2008 annual budget audit by the U.S. Government Accountability Office. It shows that the U.S. government must roll over $3.4 trillion in debt over the next four years. This $3.4 trillion does not include any additional borrowing that may be required for other government programs (wars, healthcare, wars, school lunches).

What's the big deal? $3.4 trillion is a small number by today's standards, isn't it? Not exactly.

The chart shows how incredibly interest-rate sensitive U.S. government borrowing now is. Not only is it a big ask to ask the world's creditors to continue funding such large deficits (there are only so many savings available to borrow, after all), but the interest expense on that debt is likely to go up as the fiscal position of America deteriorates.

And if America can't find anyone willing to finance its deficits, what then? Well, the luxury of issuing debts in the currency you also print is that you can print money to pay for them. Technically, you can never become insolvent when you enjoy this privilege. The Fed, for example, can create new money to buy debt issued by the Treasury, funding deficits ad infinitum.

But this monetisation of the debt is another way of saying that international creditors are no longer willing to pick up America's spending tab. They will be betting against the American economy, not on it. Even if the Fed takes the unusual step of moving out further along on the yield curve to set interest rates (and keep the bond vigilantes from sending yields to the moon) this is a clear signal to owners of dollar-denominated assets and holders of dollar currency reserves to get out.

Another scenario to watch for is when creditors begin asking the U.S. to issue debts in currencies other than its own (Yuan, Euros). That would be something. In the meantime, they will look to lessen their dollar reserves.

That may not be such an orderly process. And the urgency to get out of the greenback and into something better will only pick up pace as it becomes clear the politicians in America (along with the Fed) are not likely to suddenly rediscover fiscal prudence.

You never know. The Fed may assert its independence and baulk at more quantitative easing. But we wouldn't count on it. And we reckon tangible assets and possibly emerging market equities would be the biggest beneficiaries of capital flows out of the dollar...and into anything else.

The next chart is for you, Paul Krugman. Krugman, among others, continues to insist that larger public sector deficits are necessary if the Western world is to avoid a Japanese-style deflationary "Lost Decade." He claims the government must increase spending as households and businesses deleverage and reduce debts.

Advocates of this idea claim that public sector deficits, as a percentage of GDP, have no real limits. And the example they cite is Japan. As you can see from the chart below, Japan's debt to GDP ratio is nearing 200%. America's isn't even half of that yet (it's about 98%, or $13 trillion). If Japan can finance a deficit at 200% of GDP, then why are we worried that U.S. deficits half that size would threaten interest rates or the dollar?

First off, it's worth pointing out that high public sector-debt-to GDP ratios haven't worked in Japan, if by work you mean pave the way to a stable recovery. Advocates might say-as advocates of the stimulus here in Australia often say-that the public spending made things less worse. But the opposite is true. It's made things more bad!

Or just worse, if you prefer. We mean that the public spending has done two things, neither of which is productive, and both of which, in fact, waste capital and resources. First, public sector spending to prop up financial firms with dodgy assets prevents the needed reckoning in asset prices that would produce market clearing prices for commercial and residential real estate. You get zombie banks and a zombie economy and zombie house prices.

Secondly, there's no indication that all the infrastructure spending in Japan has produced any kind of lasting growth for the economy. It may have built some great roads and bridges. But we wonder if it solved any of the underlying problems? What' more, the capital and resources that went into those projects was directed by political considerations and not available for the private sector, which could have put them to some use at least designed to produce a return on the capital.

The underlying problem which deficit spending does not solve is compounded by demographics. Japan's government is hoping that continued borrowing can be financed at low rates by pensioners who will be cashing out of their pensions but seeking safety. However, we suspect that Japanese pensioners will begin to consume their savings as they downsize their lives into their twilight years (which tend to last much longer in Japan, as the number of Japanese centenarians shows).

That means interest on Japanese bonds-which already one fifth of the Japanese budget-will consume even more of the nation's resources, if the older population clams up with its money. And like in the U.S., you'll see the government borrowing more and more of every new yen spent, with more of that borrowed yen going to pay a previous creditor. That's bordering on Ponzidom.

Japan has been able to run a higher-than-average public debt-to-GDP ratio because it has had such a high personal savings rates. This kept borrowing costs low for the government. But we'd expect that to change soon. A debt-to-GDP ratio of 200% will be very difficult to finance in the world as it is-much less in a world where those rates begin to rise and when Japanese savers begin to consume their savings.

Finally, what about Europe? Our argument here is simple: Europe's monetary union is going to come unstuck. Why? Europe has one interest rate for twelve different economies. That does not leave national governments with the flexibility to print money and inflate away political problems. This will be intolerable, the monetary union will break up.

The sign to watch for is a spike in the yields on euro-denominated debt. As the chart below (from Stratfor) shows, earlier this year bond yields did in fact begin to widen. Germany Bunds have the most stable rates, as Germany has traditionally the most stable fiscal and monetary policies in Europe (they did not go hog wild for stimulus).

But for Spain, Ireland, Greece, Portugal, Italy and Austria (whose banks lent large for real estate in Eastern Europe), another round of falling asset values really would show that the GFC has become a sovereign debt crisis. And will Germany bail out these nations? Can it afford to?

We don't know the answer to those questions. But it is worth pointing out that by assuming or guaranteeing the liabilities of the financial sector, national governments have also assumed the risk. And the bond markets will be left to decide how to price this risk.

How it ends is anyone's guess. But our take is that the Super Cycle in fiat money is at its peak. And as it unwinds, it's going to take national governments and their financing model with it. They will be forced to adopt a new model and take a new form to survive.

This means a great deal of political and economic upheaval. It's no coincidence that the last time the world faced such monetary upheaval was when it went off the gold standard and straight into essentially thirty two years of military and economic conflict (1913-1945). If the world is about to become that disordered again, you'll need a plan to deal with it.

Dan Denning
for The Daily Reckoning Australia

• Government Debt
• Zero Percent Interest Rate Didn’t Work for the Japanese
• AIG to Receive $85 Billion Loan from Fed
• China Reduces Holdings of Treasury Securities
• Japan “Wasted Trillions” on Stimulus Programs

Maybe it's the end of the dollar carry trade (where speculators sell risk assets). Or maybe not. Whether that little thesis turns out to be correct we'll know in due time.

In the meantime, there are some other things we might learn this week. First up is the TD Securities - Melbourne Institute Inflation Gauge. This will probably show that except for food, fuel, energy, healthcare, and housing, prices in the economy are stable and inflation is contained.

One quick note about this: there is obviously plenty of inflation in the prices you pay every day. But most consumer price indices are rigged to understate inflation, as our colleague David Evans pointed out yesterday in Canberra at the Gold Standard Institute conference in Canberra. Trimmed medians...hedonic adjustments...there's quite a bit of statistical hocus pocus going on.

Inflation is evident if you just follow the money. The returns on wealth (rent, capital gains, income from bonds) are accruing to that group that's benefitted the most from low rates. Dr. Michael Hudson called them the 'financial oligarchy' in his recent trip to Australia. This group has benefitted from inflation in the form of higher asset prices. And meanwhile, the Fed and other central banks have been able to say their policies are not inflationary because consumer prices and, more importantly, wages, aren't moving up.

Duh.

Is it really a surprise that there's no inflation in wages in a world where tens of millions of workers in emerging market economies are willing to do the same work as those in Western economies, but at much lower prices? Wage deflation is the order of the decade. Maybe the century. You generally won't find inflation in consumer prices or wages. But that doesn't mean it isn't there.

So what will the Fed and the Reserve Bank do this week? The RBA meets tomorrow and everyone is expecting another rate rise. The Aussie dollar has all but priced it in. The RBA also puts out its commodity price index week and its always exciting quarterly statement on monetary policy which we just can't wait to pore over for signs of continued credit and debt growth in the Australian economy.

Westpac will also post results this week. If it follows the lead of NAB and ANZ, it will report higher-than-expected bad debts, but claim the bad debt cycle has peaked. Don't be so sure, though. And why not?

Well, over the weekend, CIT Group Inc. (NYSE:CIT), with US$71 billion in assets, filed for the fifth-largest bankruptcy in American history. CIT is the latest victim of the credit crunch, which obviously still isn't over. It's a commercial lender to small businesses that's been unable to refinance its debt. As a non-deposit taking bank holding company, it has to finance asset growth through securitisation and borrowing, both of which are still pretty hard to do these days.

CIT's Chapter 11 allows it to restructure under the protection of the courts. Bondholders might make out okay. The U.S. Treasury, though, has already lost $2.3 billion in TARP money it put into the firm. And the biggest losers are the small businesses who will no longer have financing. That's bad news for the real economy.

As deposit taking institutions, the Big Four Aussie banks are not nearly as vulnerable to this kind of crisis as CIT obviously was. But as we showed last week, Aussie banks still rely on quite a bit of short-term borrowing in the wholesale funds market abroad, borrowing money from foreigners to financing lending here. That's always going to be a weakness.

Hold everything!

Last week we warned that a result of the Fed's low rates is that U.S. banks have stocked up on U.S. Treasury bonds and notes to stabilise their balance sheets. We warned that this could put the banks at risk again, IF the value of those bonds was slashed by market forces. You'd get another bank collateral wipe-out which could, if large enough, wipe out equity. Insolvency becomes an issue again.

But don't underestimate the ability of the bond bubble to go on longer than anyone thinks. The Feds meet this week and will probably not change a thing. Its formal program to buy Treasury bonds and mortgage backed securities with newly created central bank reserves (quantitative easing) can always be extended. So should bond bears like your editor (who agrees that U.S. Treasury bonds are a great short) be wary?

Yes!

The reason is a new regulation passed by Britain's Financial Services Authority which lays out new liquidity rules for bank assets. Rolfe Winkler has the story in his blog. The short version is that the FSA may require banks to own a certain percentage of assets that can quickly be liquidated to raise cash if need be. Lower credit quality assets (junk bonds or lower rated corporate bonds) might not qualify.

What that means - if you read between the lines - is that the only assets which would meet the new liquidity requirements from the FSA are sovereign government bonds. Now maybe this does make bank assets more liquid. But we wouldn't say owning more government bonds makes bank assets any safer, or improves the capital position of the financial sector.

What it DOES do is give the government a way to force new bond issues down the throats of banks. Rather than having to find creditors among the high-saving emerging market nations, governments in the UK and the US would have a captive market in their own financial sector. The banks would gradually gorge themselves on sovereign government debt, provided Moody's or Fitch or Standard and Poor's didn't downgrade the credit ratings of the US and the UK.

It sure looks like another move toward the nationalisation of the financial sector, although in a very clever way. And the banks probably don't mind that much right now. Trading government bonds with new Fed money was a virtually risk-free trade that propped up bank profits in the first half of the year. It's a good trade.

But in the bigger picture, as Nial Ferguson and Ken Rogoff mentioned this weekend, this means that the financial crisis may soon become a sovereign debt crisis. So far, the liabilities of financial firms have been transferred to the public sector balance sheet. But this has not solved the problem. It's merely moved it to a larger stage on which it must play out.

As we mentioned in our remarks yesterday at the gold show, we believe this marks the beginning of the end of the Super Cycle in paper money. A sovereign debt crisis is the same as saying that the funding model for the fiscal welfare state is broken. Only in this case, there is no organisation large enough to bail out the fiscal welfare state. What does that mean? More on the consequences, and the opportunities tomorrow.

"This is the first time I've been in Canberra," we began our remarks yesterday. "I spent most of last night trying to figure out what it reminded me of. And then it came to me. It reminded me of Washington D.C., and not in a good way. I spent four years in college living in DC. Both cities make you feel like you've stepped onto a very orderly and sterile brothel."

Dan Denning
for The Daily Reckoning Australia

• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Hyperinflation and the Dollar’s Monetary Destiny
• Everyone We Know Expects a Fairly Quick Up-move in Inflation
• The Asian Banks Have Finally Been Heard From
• Australia to Borrow as Much as $300 billion

Don't believe the hype, though. The big problems in the economy—too much debt, too much leverage, too much government—are still there. They didn't go anywhere overnight. We'd suggest that getting sucked back into stocks now because of the US GDP figure is a very bad idea.

Of course we could be wrong. Maybe stocks will go up another 20% from here. Or 30%. Or 50%. But it's not likely. It's more likely that the recession is over, but that the Depression has just begun.

It's begun because what the US GDP numbers actually show is a private sector in full retreat as its income shrinks, its assets fall in value, and the cost of servicing debt rises. Into that terrible breach the public sector has stepped, armed with an arsenal of inefficient and stupid programs that give the illusion of economic activity but actually prevent the economy from liquidating excess capacity and bad debt (the two conditions required for a real recovery).

So we're sorry to have to ruin your Friday making this point. But there are actually a couple of points we have to make with regard to US GDP to show that its effects on the Aussie market are not as benign as you might think. Just the opposite really.

The GDP figures presage a massive increase in government spending in America and elsewhere. This debt binge is driving the public sector ever closer to its own reckoning with Ponzi Finance—where new debt barely covers the cost of interest and principal payments on old debt.

But again, why so serious? Shouldn't we celebrate? U.S. GDP has contracted each of the last four quarters. We are not going to rain on the parade by trying to prove that it didn't grow. But the real question is whether the GDP figures show that the economy is recovering, or whether a quarter or two of government intervention can give the economy a healthy looking flush, while concealing the disease that is eating away at its insides.

It all depends on what kind of recession we had. In a garden variety recession, businesses build up too much capacity in anticipation of consumer demand that never materialises or suddenly vanishes. Think of the U.S. housing boom. Its seeds were sown when homebuilders built way too many units in places like Nevada, California, and Florida.

They failed to realise that soaring demand for these units was driven by the supply of cheap credit. When the credit dried up, so did the demand. And the homebuilders were left a massive over-supply of housing. The ones that survived had to liquidate inventory (land as well) at bargain prices.

Excess productive capacity is exactly what gets liquidated in a normal recession. Inefficient producers of goods and services get booted from the marketplace. Inventories are worked down until they are in line with a lower level of demand. And then, maybe, the economy starts a new cycle.

But what we have here, dear reader, is not a garden variety recession. While it's true that there is a huge amount of excess capacity in the world economy (hence wage deflation in the West), there is also another, more serious problem: too much private and household debt. That is what makes this, as others have written before, a balance sheet recession.

You get a balance sheet recession when households and businesses must reduce the amount of debt they have. They "must" do this because cash flows aren't robust enough to service accumulated debt AND send little Timmy to private school (in the case of households). People have to cut back until expenses are less than income.

Or (in the case of a business), they must cut back because the cash flow isn't robust enough to cover the interest and principal payments on existing debt AND finance the operating expenses of the business. Businesses have to shift back to investing in capital goods and new growth, rather than speculating in financial assets and paper wealth.

There is no escaping a generation of accumulated debt. When the cost of debt begins to consume most of your free cash flow, well, sooner or later you have no free cash flow. There's nothing left. You're spending every last dollar maintaining your household, paying your mortgage, and putting gas in the car. This doesn't leave room for much else—unless someone gives you money to spend (aha!).

For the last four quarters, American households have been reducing debt in order to get their financial house back in order. They are no longer borrowing against the equity in their house (because that equity is vanishing or has vanished) or spending their capital gains in stocks on a new TV (because those capital gains are smaller too). Instead, they have been de-leveraging.

Did all that really change in just one short quarter? No. What happened in the last quarter is that the U.S. government gave people money, albeit indirectly. The Commerce Department reported that real personal consumption expenditures increased 3.4% in the quarter. They had declined by nearly one percent in the second quarter. So people spent money.

But whose money, and on what?

According to the Commerce Department, "Durable goods increased 22.3%, in contrast to a decrease of 5.6% in the second quarter. The third-quarter increase largely reflected motor vehicle purchases under the Consumer Assistance to Recycle and Save Act of 2009 (popularly called, 'Cash for Clunkers' Program)."

All up, the Feds tells us that (see page seven) the "Cash for Clunkers" program added about 1.66% to third quarter GDP. Keep in mind that in September, car sales fell 40% from August levels. Either the program will have to be extended, or it's shot its one-time stimulus bolt. But what a bolt it was!

Unless we're mistaken, however, about half the GDP growth came from one government program that's expiring and stopped working in September. Chuck in another half a percentage point due to the tax credit for new house buyers (sound familiar?), and another half point from the 7.9% increase in government spending—and you get your 3.5% GDP growth.

That's it, then? The government pours billions of dollars into the real economy and trillions into the financial sector to support bankers, and all we get is more cars and more houses bought by people with credit provided by a government that doesn't have any? That's a recovery? That's the tipping point?

Excuse our scepticism. It's not like household balance sheets improved that much in the last three months. In the very same glowing press release that announced the 3.5% growth, we learn that people had less disposable income in September, despite the rosy growth number.
"Disposable personal income decreased $20.4 billion (0.7 percent) in the third quarter, in contrast to an increase of $138.2 billion (5.2 percent) in the second. Real disposable personal income decreased 3.4 percent, in contrast to an increase of 3.8 percent."
That sounds like households—when they are not spending government money on houses and cars—are still cutting back. They're cutting back because there's no wage growth in the economy and no job growth. But there is still a lot of debt!
"What destroys individuals, ruins families, and fells nations is debt—or rather the inability to service debt, and the cultural ramifications that follow," writes Victor Davis Hanson. Attitudes to debt are both private and collective. And they tell you something about the people you are, or are becoming.

Take classical Greece. Hanson writes that, "The difference between the 5th century BC and late 4th century BC Athens is debt-and not caused just by military expenditures or war; the claims on Athenian entitlements grew by the 350s, even as forced liturgies on the productive classes increased, even as the treasury emptied.

"At Rome by the mid-3rd century AD the state was essentially bribing its own citizens to behave by expanding the bread and circuses dole, while tax avoidance became an art form, while the Roman state tried everything from price controls to inflating the coinage to meet services and pay public debts."

Speaking of Rome, Barack Obama's pick to run America's National Endowent for the arts has recently said that, "Barack Obama is the most powerful writer since Julius Caesar." If that's the case, we suggest a new slogan to replace "Hope and Change" for the President: We came, we saw, we spent!

Dan Denning
for The Daily Reckoning Australia

• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• How Much Worse Can the Stock Market Get? A Lot Worse
• GDP Grew Substantially During the Last 8 Years but People Actually Got Poorer
• September is the Best Month for Gold
• Saving Money, Not Spending it, is the Key to Getting Wealthier

"Okay."

"Why so serious? I mean, all you do every day is write about the worst-case scenario. It's depressing. Who died and made you the harbinger of financial doom? How about something positive for a change?"

"Is that code for, 'buy me another beer?'"

"No, seriously. It's not all bad all the time is it?"

We'll tell you how we answered our friend's question below. But first up, the markets. It was another red day in New York, with Dow stocks down over one percent. Tech stocks on the Nasdaq - the ones enjoying a bit of euphoria renaissance - were down 2.67%. September new home sales in the U.S. fell 3.6% from the month before. The Aussie dollar shed 1.44% against the greenback.

Is that all just noise? Or is there a melody building in the markets? The chorus chanted by Ken Henry, Wayne Swann, and most of the media is that the strong Aussie dollar, the strong market, and the strong(ish) economy are all factors of Australia's great policymaking and unique relationship to the China boom.

But the alternative tune - the one which we've been humming - is that most of the rally in stocks since March and most of the 30% rise in the Aussie dollar is a result of the carry trade. Yes, Aussie assets are relatively more attractive when the cost of capital in the U.S. is zero. But this can change in a flash when foreign speculators change their trading minds.

That's just what happened last year. Only then, it was both a dollar and yen carry trade that led to a rise in Aussie assets. Once the credit crisis set in, the yen carry got dropped and investors fled risk assets and piled right back into the greenback and U.S. Treasuries. Stocks fell, commodities fell, and the Aussie dollar plummeted to nearly 60 cents against the USD.

It doesn't have to happen that way now just because it happened that way then. But since our main job here is to question conventional wisdom and offer you an alternative explanation, that's the one we're offering you. Beware carry trades promising false permanent prosperity!

But what about today's earnings? ANZ followed up yesterday's bad debts bonanza from NAB with one of its own. ANZ reported an 11% fall in net profits (to $2.94 billion) and a 46% rise in bad debts to $3 billion. But both banks hinted that the end of the "bad debt cycle" is over and that things can only get better.

Let's take the other side of that trade. Again we'll focus on two risks: access to foreign funding and asset values on the balance sheet. ANZ sourced more of its funding from domestic savers and less from short-term whole sale funding, according to its report. Aussie savers funded 55% of ANZ new loans for the year (up from 50%) while the company reduced its reliance on short-term whole sale funding by 17% (now just 17% of all funding).

What does that mean? It means the company is making plenty of new loans (you'd want to, especially to the housing market, to prop up the value of your real estate portfolio). But it means the company is relying a lot less on short-term borrowed money from overseas in order to boost lending to Aussie homes and businesses.

Whether it is doing this by necessity or by choice is big question. But all we want to point out is that if your economy relies on imported capital to finance investment (or consumer spending, or new mortgage lending) you're vulnerable if that capital is not forthcoming. It's great when the dollar is high and capital is flowing. But if those capital flows reverse, the banks may find themselves in a jam that even a government guarantee makes it hard to escape.

It's not just us saying this, by the way. "We need to figure out how we can become less dependent on wholesale funding to finance our economic growth," said Commonwealth Bank of Australia chairman John Schubert in last Friday's Australian Financial Review. "It is not assured that we will get the funding into the future."

No foreign funding, no continued housing boom. In fact, we'd be willing to say that a cut off from short-term wholesale foreign funding is just the sort of thing that could lead to a major correction in Aussie house values. Naturally, the government here would step into the mortgage finance market in a big way, and not just for non-bank lenders, as it's done with the Australian Office of Financial Management buying securitised residential mortgage backed securities.

The U.S. government has done everything it can to keep the mortgage credit flowing and household net worth from imploding. Australia would do the same if it had to. But like in the U.S., this means more government borrowing to prop up the property market. More debt, higher interest payments, less capital available for lending to the rest of the economy.

But let's assume for now the public sector does not enlarge again to Depression-era levels of debt. Let's assume that Aussie banks have access to overseas credit. There is still the issue of asset values. ANZ says it is leveraged about 17 to 1. With $476 billion assets, that leaves it with about $28 billion in equity (according to how it calculates both assets and equity). And like yesterday, it's fair to say that a few billion in loan losses and bad debts are hardly the sort of thing to wipe out that much equity.

That's not where the real risk is, though. The real risk is to the asset portfolio. Twenty eight billion in equity capital is just under 6% of total assets. Or, put another way, a 6% loss in assets wipes out the equity.

A six percent loss in assets? Is that possible? The IMF and APRA have stress tested Aussie banks for scenarios in which large chunks of homeowners can't pay their mortgages. They chuck in large corporate bond default rates just to make things more stressful. And after all that, they've concluded that most of the banks' assets are solid and safe and unlikely to incur mammoth losses that would jeopardise the equity capital (solvency).

And maybe they are right. But we're just saying...in a world dominated by massive credit write downs...where we have just seen six months of re-leveraging...and where house values here in Australia have managed (thus far) to escape massive deflation...is a six percent loss on assets totally unimaginable?

We can imagine it, although we don't relish it. Either way, we wouldn't buy the banks just now.

But if you're looking for the most over-valued asset class in the world - the one worth a punt for going short - it has to be U.S. government bonds. Paolo Pelligrini, the man who helped John Paulson make a mint shorting the U.S. housing market, told Bloomberg that shorting long-term U.S. debt is the "only attractive bet" going at the moment.

"I always like to think about assets that are likely to experience a breakdown; the only thing I'm pretty comfortable with right now is U.S. Treasury securities and U.S. agency mortgage-backed securities...I think that those are overpriced so they are attractive shorts."

If you're not going to short the U.S. long-term bond market any time soon, the take away from this is to look for assets that go up when U.S. bond prices fall. If U.S. bond prices fall it means U.S. interest rates go up. That might, for a bit anyway, lead to a stronger USD and a weaker AUD.

For a trader - other than cash and gold - we'd look to see which of those Aussie stocks hammered by the stronger Aussie dollar have been beaten down the most. They might be due for a quick rebound - although they will be fighting the general trend in the market. We'll ask Murray what he thinks and get back to you.

So what did we tell our drunk friend when he asked us why were so critical, sceptical, negative, and gloomy all the time?

"Relax dude. It's my job to plan for the worst case scenario. It makes me happy to have a purpose in life. If you want the best case, turn the TV on and turn your brain off. And I object to your overly negative characterisation of my work."

"Huh?"

"My work isn't negative. It only seems that way because we live in a period of wealth destruction. I wish it were a world of wealth creation. But in a world of wealth destruction, you have to focus on preserving your wealth and maybe, when you can, growing it if you've got the big picture sorted out correctly."

"But you make it sound like the end of the world every day."

"It is the end of the world every day. But it starts all over the next day. And it is just the end of the financial world as we know it. Not the end of the world world...Besides, it's a lot less scary when you face up to what is really going on and make a plan for it. Uncertainty is scarier than risk because with uncertainty, you have no idea what to expect. Risk you can at least manage."

"But how can you be so sure you're right about the big picture? Everyone else I talk to says there's no way the dollar is going down as a reserve currency and that only kooks believe that. Are you a kook?"

"Certified. But that doesn't mean I'm wrong. You can't keep adding debt forever to fund your way of life. Debts have to be repaid. And interest has to be paid on the money you've borrowed. The politicians in America keep making new promises they aim to keep with borrowed money. This borrowed money is massively interest rate sensitive. And it's in addition to a huge amount of money they've already borrowed. It's the end-game for the whole financial/fiscal/political model."

"But so what? Isn't everyone else doing the same thing?"

"Well yeah. All fiat money is a scam. It's a way for the government to run perpetual debts and steal savings through inflation. It's an immoral living arrangement in that respect. But more importantly, from a financial perspective, it's a way of funding a political arrangement. And that way of funding it - borrowing more and raising taxes on a small productive class to pay for a larger public sector - is every bit as dead as the funding model for investment banks."

"But the government bailed out the investment banks. Who is going to bail out the government?"

"No one. Nothing. It will try inflation. But that doesn't work. Printing more money to pay off your debts just destroys wealth. That's where we're headed. That's what you should plan for. Sooner, not later."

"I would like to begin my plan with another beer, if it's all the same to you."

"No worries."

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• IMF Report Concludes Aussie Banks are “Very Sound”…
• A National Mortgage Bubble
• Fed Now the Middle Man in Interbank Lending Market
• Corporate Debt is Just One Aspect of the National Debt Problem

If you want to attend the presentations and discussions over the next four days, you can still do so. But you should contact conference organiser Marcus Matthews today. You can reach him via email at feketeaustralia@gmail.com. And if you're there on Sunday, be sure to say hello.

Yesterday we promised to show you how the funding model for the fiscal welfare state is blowing up. But this is going to have to wait at least another day. Don't worry though. It's not going anywhere.

Today, there is a banking story to cover. You recall that yesterday we were worried about the next banking crisis. But the lingering effects of the last one are still with us. National Australia Bank reported a 43% fall in net profit yesterday. Ouch.

Don't feel too bad for NAB. Net profit fell from $4.54 billion to $2.56 billion. But the bad and doubtful debts charge for the year grew by 53% from $2.49 billion to $3.82 billion. With $654 billion in assets and $616 billion in liabilities, the bank is sitting on $37.8 in equity. A few billion in bad debts and loan losses won't wipe out that amount of equity.

But it's worth noting that NAB's total assets are 17.3x times equity. This isn't as high as some leverage ratios in the U.S. just prior to the banking crisis in 2008. But it's not far off where NAB was at the time. And there are two further risks worth mentioning.

First, as the IMF paper on Aussie banks concluded earlier this year, Aussie banks are probably strong enough to withstand a normal shock to the balance sheet. That is, the IMF stress-tested Aussie banks for losses on their two largest loan portfolios - corporate loans and mortgages. The IMF concluded the banks were adequately capitalised to survive the shocks it tested for, but that, "The above shocks do not constitute a rigorous stress test and the results are only indicative of the health of the banking sector."

If we've learned one thing in the last two years, it's that bankers and analysts have consistently underestimated the frequency and magnitude of systemic shocks. That doesn't mean the IMF conclusions aren't to be trusted. But it means in the event of another more severe shock, the banks could face larger asset writedowns and losses than the IMF has modelled.

This brings us to the second risk worth mentioning. A bank facing bigger loan losses takes fewer risks. It reduces lending. This is how the credit crisis was transmitted from America's housing market to Australia's economy. The Aussie banks had to tighten up to prepare for losses on overseas assets.

Next time around, though, we reckon the losses - when they come - will be on domestic real estate assets. And with so much exposure to domestic real estate (mortgage loans), the assets could face a world of hurt. But even if bank asset quality doesn't crash (housing prices don't crash), an external shock affects Aussie bank liabilities.

The IMF report says that, "On the liabilities side, however, banks had sizable short-term external debt obligations, and access to offshore wholesale markets was disrupted by the Lehman Brothers collapse in September 2008." Of course the government's wholesale funding guarantee eased the pain of this shock, which is one reason why that guarantee may become permanent in all but name.

But the IMF wrote that, "A key remaining vulnerability is the roll-over risk associated with sizable short-term external debt. Banks' wholesale funding (domestic and offshore) accounts for about 50 percent of total funding, of which about 60 percent is offshore. Financial institutions short-term external debt (on a residual maturity basis) is estimated by staff at about $A 400 billion (35 percent of GDP) in March 2009."

Maybe the short-term external debt levels have improved in the last six months. We haven't checked yet. But in simple terms, it means a lot of domestic lending is funding from external funding, borrowing abroad to loan at home. If American banks again blow up on the destruction of their remaining collateral (mortgage loans and U.S. Treasury bonds) we'd predict another ice age in global credit markets.

Needless to say, as a capital importer, this would put Australia in an awfully uncomfortable spot. But hey! No one is worried about that at the moment. The Aussie dollar is being inflated by the U.S. dollar carry trade. It's a shame that the strong Aussie is going to devastate local industry and manufacturing with higher costs, but at least it obscures for now the risk that Aussie banks are reliant on foreign borrowing.

In the bigger picture, this means the investment needs of the economy can't be met by household savings alone. But that's an even bigger problem than we can address today. So we won't!

More cow bell!

And what about our theory that a U.S. dollar rally will trigger a correction in gold, oil, and stock markets and lead to a mini-rally in U.S. Treasury bonds? Bond fund king Bill Gross agrees. Writing on Pimco's website, Gross concedes, "Rage, rage, against this conclusion if you wish, but the six-month rally in risk assets -- while still continuously supported by Fed and Treasury policy makers -- is likely at its pinnacle."

Dr. Doom himself, analyst Nouriel Roubini, called the present market "The mother of all carry trades." "This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals," Roubini said via satellite to a conference in Cape Town, South Africa. "The risk is that we are planting the seeds of the next financial crisis."

With the S&P up nearly 65% since touching 666 in March (seriously), we'd say the seeds are already bearing fruit. But maybe it's poisoned fruit. After all, the rally has been worldwide and extremely impressive by historical standards. But it's fully consistent with previous bear market rallies. If anything, it's happened faster.

What nobody yet knows is if it IS a bear market rally...or a garden variety stock market rally that precedes a recovery in the economy. You know what we think.

There IS one notable difference between 2008 and today, though. Yesterday we mentioned that U.S. banks have loaded up on a whole other kind of super-dodgy collateral; U.S. Treasury notes and bonds. Demand for those securities may go up with a U.S. dollar rally and a reversal of the dollar carry trade. But in the longer-term, we think the banks have invited another toxic house guest on to the balance sheet.

But where did the previous smelly houseguest go? You know, all those mortgage backed securities and subprime loans? Where does that risk now reside? And what happens if it comes home to roost?

According to this report by the San Francisco Federal Reserve, over 95% of all new residential mortgage lending in the U.S. is now being backed directly by the U.S. government. With the banks unable or unwilling to lend, Uncle Sam has become the sugar daddy of the U.S. mortgage market. See the chart below.

The Fed supports this market by purchasing the securitised mortgages issued by Fannie and Freddie. The Congress funds the agencies which make the loans available. But no matter how you slice it, the U.S. government is supporting the housing market. It will continue to do so as a political imperative.

But by taking on this massive liability - not that it doesn't already have its hands full - the Fed is further consigning the dollar to the scrapheap of history. Do you think foreign creditors will not realise that the U.S. is borrowing money to keep house prices elevated? Will they not notice that the U.S. is printing money to do this? And what will happen to the dollar then? And gold?

The truth is that creditors already do know this. Today's Australian Financial Review reports that overseas Chinese investment is "surging." Chinese policy makers are trying to trade dollars for tangible assets or equity in resource shares as quickly as possible. "China reported a 190% jump in overseas investment by its companies for the third quarter."

"Policymakers might be encouraging Chinese firms to invest abroad, in part to help counter pressure for the nation's currency," the article continued. "Investors are betting on the yuan to appreciate as China's growth accelerates from its weakest pace in a year."

Most currencies that are not the U.S. dollar could appreciate in the coming years. Australia's currency has already done so. Brazil is considering a tax on capital flows into the country in order to prevent investors from speculating on a further rise in its currency by buying Brazilian assets. And of course speculators have tried for years to find a way to position themselves for an appreciation in China's currency. China's capital markets are not friendly in this regard, although Hong Kong stocks remain a popular option.

The fact that countries like Australia, China, and Brazil are trying to limit currency appreciation versus the greenback shows you how unbalanced the world economy still is, how unprepared it is for the reality that America's deleveraging will take place for years. Households and businesses must save and repair balance sheets. Some other country is going to have to consume what the world produces.

In the interim, the U.S. government will increase deficit spending to make up the difference. It is the stupidity of Keynesianism to support aggregate demand when what everyone needs is a correction and a recovery. But all the Feds will succeed in doing is blowing up the balance sheet of the U.S. government in spectacular fashion. Go gold.

Mind you we still think the short-term move is a dollar rally and some profit-taking on the dollar carry trade. We asked Slipstream Trader Murray Dawes what he sees when looking at the U.S. dollar index. Murray spends most of his time finding trading opportunities in Aussie stocks. But he also knows that Aussie markets (and capital flows) are still massively affected by what's going on in America.

Murray wrote that, "If we look at this chart of the US Dollar index going back to 1985, you can see quite clearly that the 10 week moving average crossing over the 35 week moving average has been a very good indicator of the trend. There are only a few instances over that whole time period where this indicator gave a false signal."

Click to enlarge

"Therefore," Murray continues, "we should be keeping an eye on this indicator going forward to tell us whether the US Dollar index has turned back up and is ready for a counter trend rally. The short US Dollar trade is getting pretty full, as I have mentioned in the past. And there is a high correlation between the direction of the dollar and the direction of gold, oil and stocks.

"The US Dollar has taken over the Yens role of funding the carry trade and this will be the situation for as long as the Fed remains too scared to raise rates, which seems to be for the foreseeable future. So we can probably expect the dollar to weaken further over the long term, but a counter trend rally (short squeeze) may be closer than people think and this would lead to weakness in commodities and stocks.

"When should we trade this move? Well have a look at the chart again. Notice the false breaks that keep occurring when the all time lows get breached (denoted by the numbers 1,2,3). With the trend still strongly down we can expect to see either a false break of the lows around 71 reached last year or if that doesn't occur then a crossover of the 10 week/35 week moving average to confirm that the trend has changed. Trading the move before either of these are confirmed would be jumping the gun."

Murray is tracking which Aussie stocks will move if and when we see the dollar index break out. We'll keep you posted.

Dan Denning
for The Daily Reckoning Australia

• Rally in Stocks and Rise in Aussie Dollar is a Result of the Carry Trade
• IMF Report Concludes Aussie Banks are “Very Sound”…
• A National Mortgage Bubble
• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• How Did Australia Get Caught Up Losing Money in Commercial U.S. Real Estate?

But a warning about what? Sure, stocks, oil, and gold were all down yesterday and the U.S. dollar was up. But is it really the end of the dollar carry trade? And if it is, what happens next?

More cow bell!

We should back up a second. What is the dollar carry trade? It's the engine of bank profit growth this year. It's what's given the illusion that the financial system has recovered from its brush with death last year.

But as you'll learn today, the bankers, the Fed, the media...the whole lot of them...have learned nothing from last year. The hangover was just beginning to set in, so everyone began drinking again heavily. And now the party is wild and out of control. Even the cops are drunk.

Incidentally, this complete abandonment of monetary sobriety and fiscal prudence shows up every day in real life, where the declining value of money is paralleled by a general decline in public behaviour. For example, on Sunday morning we were tucking into a breakfast of banana caramel pancakes (with a scoop of vanilla ice cream on the top) when three incredibly drunk but fairly well dressed middle aged men had a seat next to us at the cafe.

They wanted to chat about the John Birmingham book on the table. They wanted to smoke. They wanted to laugh, and did so loudly to the point where they began upsetting the various dogs assembled in the sun. They ordered a pitcher of beer. They were served. It was 9am and they hadn't been to sleep.

Our cow bell tells us that the financial party thrown by Ben Bernanke may soon be ending. The dollar carry trade, by the way, is where financial firms and speculators borrow cheap money in the U.S. and use it to buy higher yielding assets elsewhere (like the Aussie dollar).

The carry trade is a bubble enabler and balance sheet stabiliser in the short-term. The Fed keeps rates low, the banks borrow and then buy U.S. bonds (which helps the U.S. fund its deficit), buy stocks, and buy commodities. The dollar carry has fuelled the world-wide rally more so than any phantom recovery in the real economy, where employment hasn't recovered and wage growth is hard to find.

What the carry trade has not done is fundamentally improved the balance sheets of the very financial firms that were at risk of insolvency last year. Why not? First, the earnings rebound in the first three months of the year was not driven by better business conditions. Speaking to the Financial Times earlier this week, George Soros said, "Those earnings are not the achievement of risk-takers...These are gifts, hidden gifts, from the government."

The banks booked profits from trading stocks and bonds. And because the Fed, through quantitative easing, was supporting bond prices directly, it was as close to free money/a rigged market as you can get. With enough leverage, even small gains in bond prices were bankable.

But now there is an enormous, gut busting irony to the position the banks find themselves in. Remember that the original idea to repair bank balance sheets and restore their capital positions to healthier levels was to replace toxic mortgage-backed debt with safe, sound, and liquid U.S. Treasuries. Snort. Guffaw.

The irony is that those same Treasuries could be the next big blow up, wiping out the banks thin equity capital sliver all over again, and plunging the financial sector into a second wracking round of forced deleveraging and asset sales. Round two of the recession, morphing into a Depression as the public sector ramps up deficit spending to make up for the collapse in household and business spending.

We all know how much serious the cycle of deleveraging and asset sales was last time around, so it's not a claim we'd make lightly, or without some evidence. So let's get to the evidence. First is an article from Gillian Tett, also in yesterday's FT, titled "Rally fuelled by cheap money brings a sense of foreboding."

"Earlier this month," she begins, "I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets - and was feeling deeply shocked."

" 'Forget about the events of the past 12 months ... the punters are back punting as aggressively as ever,' he wrote. 'Highly leveraged short-term trades are back in vogue as players ... jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.'"

" 'Oh, I am sure the banks' public relations people will talk about the subdued atmosphere in banking, but don't you believe it,' he continued bitterly, noting that when money is virtually free - or, at least, at 0.5 per cent - traders feel stupid if they don't leverage up.

" 'Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,' he added. He finished with a despairing question: 'Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?'"

This 'latest bubble' is in evidence across all asset markets-bonds, stocks, commodities, property, and cash. Free money does not discriminate on the basis of asset class. But nowhere has the bubble been more generous than in the U.S. Treasury bond market. Short-term U.S. bond yields are vanishingly low. The Fed just purchased $14 billion more in mortgage-backed securities last week and now holds $776 billion in MBS and $773 billion in Treasuries. All up, the Fed's balance sheet is at $2.1 trillion.

But here is the thing: the Fed says it's ready to end its program of buying Treasuries and MBS. It realises it will have its hands full funding big U.S. deficits. But if the Fed withdraws its support for bond prices...you can expect bond prices to fall and yields to rise. This may happen even if the Fed keeps buying bonds...but creditors like the Chinese and Japanese stop (as they have done with agency securities.)

All sorts of interesting things begin to happen now, if by interesting you mean terrible but fascinating. Falling bond prices and rising yields would make perfect sense in a U.S. dollar rally. And a U.S. dollar rally makes perfect sense if the carry trade ends and the dollar shorts cover. Speculators take profits in oil, gold, stocks and jump back into cash and the greenback. This is roughly what happened last time the wheel's came off the financial system.

Where does that leave banks and their massive new hoards of U.S. Treasury bonds? An article called "Bank Insolvency Is Not A Dead Issue" by Daniel Aaronson and Lee Markowitz shows that banks have dramatically increased their holdings of U.S. Treasury securities. When you add their existing exposure to U.S. real estate (facing an Option-ARM crisis over the next twelve months) you have a huge swathe of bank collateral that could face another massive write down.

What do you think that might do the global economy? Aside from putting a few more banks out of business, it would again cut off the flow of credit to small businesses and the rest of the economy. It might again cut off the flow of bank credit from international lenders to the Big Four here in Australia. And this time, what kind of aid can the Feds really offer when their last attempt at help (exchanging Treasuries for RMBS) set the banks up for precisely the implosion they were trying to avoid?

As you can see from the chart above, banks have grown assets again with the Fed's borrowed money. You know have a freshly steaming pile of recovering asset prices supported by a thin wafer of equity capital. It's a fraud with a cherry on top. As the charts below, U.S. banks own nearly $1.5 trillion in government securities. And they are gobbling them up like there is no tomorrow.

There is always a tomorrow. But corporations and institutions live and die just like species. Only the earth abideth forever.

We reckon that the entire financial industry is still dangerously close to a species-destroying event. It's leveraged model of asset growth and debt accumulation imploded last year. But the Fed has brought it back, and like a Zombie/Frankenstein mash-up, it's here to torment us all again.

Soros told the FT this sequence of events is causing a lack of confidence in governments. "There is a general lack of confidence in currencies and a move away from currencies into real assets," he told the FT. "There is a push in gold, there's strength in oil and that is a flight from currencies."

So in the short-term, don't be surprised to see a stronger rally in the USD, which would take some of the starch out of oil and gold prices. As the dollar carry trade unwinds a bit, stock markets will fall and so will other asset classes that have zoomed up on the speculation.

But the bigger story playing out is this: the entire method by which the fiscal welfare state funds itself is blowing up. More on how this will happen and what it means tomorrow. Until then, we hope you heard the cow bell.

Dan Denning
for The Daily Reckoning Australia

• Rally in Stocks and Rise in Aussie Dollar is a Result of the Carry Trade
• Fed Announced it Would Buy up to $300 Billion in Treasury Bonds
• Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy
• It Wouldn’t be a Real Bear Market Rally if it Didn’t Test Your Confidence in Your Position
• The Only Thing Really Going Down Right Now is the U.S. Dollar

Daily Reckoning,

Mick.

Mick, you can read all about the history of the RBA here.

Dear Dan,

Colin B.

---"But if you're forwarding copyrighted material, you're breaking the law."

Peter

Peter, just because we don't like the State making rules doesn't there aren't rules for voluntary transactions that protect property rights and guarantee the terms of an exchange. The free e-mail is free. The paid services are not free. When you give them away you're giving away our intellecutal property. It's theft. Plus, it's just bad faith.

We can tell when an e-mail sent to a given address is forwarded and how many times, although we can't tell to whom (and wouldn't bother to find out.) We're not interested in getting in a fight with anyone over the issue. But we do think it's fair to ask you to quit giving away copyrighted material.

And if you don't, we'll reserve the right to terminate your subscription. We're within our rights to do that, although we'd issue a pro-rata refund as well. It's not a problem at all if you forward material from your work address to your home address. But serial offenders...

Dan Denning
for The Daily Reckoning Australia

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