Then on Tuesday the market snapped up $25 billion in ten-year notes and yields fell. Sovereign debt? Big whoop! Whether it's the end of the year and investors feel safer in Treasuries, or some other reason, Tuesday's auction showed no signs of an impending "bond fire of the vanities." The bond bubble keeps getting bigger.

Today, though, the market gagged. In an effort to lock-in low rates for longer terms, the Treasury served up $16 billion in 30-year bonds. The market turned sour. Reuter's reports that demand for the 30-year was the weakest since May and that yields moved up as the weak auction triggered selling.

And then everyone seemed to lose their nerve. Stocks fell across the board. Gold set a new high at $1,123.40 in New York trading, before retreating. The weak 30-year auction has people thinking...what happens when Treasury supply overwhelms demand?

What will happen to bond prices then? To inflation? What should I do?

The rest of today's Daily Reckoning will be devoted to some constructive apocalysm. We may have left the impression yesterday that there was nothing but pain and heartache ahead for investors. But that doesn't have to be the case. But you have to start with the big picture. And that begins with the end of the bull market in bonds.

Check out the chart below from Ron Greiss at the www.thechartstore.com. Ron's chart shows long-term U.S. bond yields since 1941. Mostly this reflects the yield on 30-year bonds, although there were periods where 30-year issuance was discontinued. Either way, it shows a great cycle...which appears to be bottoming out.

What story does this chart tell? We reckon it shows you why the U.S. government (and so many banks and borrowers) are eager to sell as much debt now as possible. Rates are near historic lows. If and when they go up, it's going to make borrowing and servicing new debt even more expensive. Bond prices will fall and yields will rise again.

Now you could say that, according to the chart, there is room for another decade of low yields. The Fed, for example, could move to set rates further out on the yield-curve. It only sets rates right now for short-term debt. But the quantitative easing program has moved the Fed out to ten-year yields. It's done this to try and keep mortgage rates low, as mortgage-rates are keyed to U.S. ten-year yields.

But we reckon not even the Fed can keep yields low forever by supporting prices. It will have to wind down its programs eventually. For example, the U.S. government ran its largest October deficit ever last month, at $176 billion. Between demographics and existing debt, the Fed may not have the resources to support bond prices too.

Besides, you'd think markets would begin to tire of U.S. debt, given the lousy fiscal position of the American government. At least that's what we'd think. And if we were trading it, we'd look for put options on ETFs that track bond prices, or call options on ETFs that track bond yields. That would be the cheap trade.

The investment decision is to find assets that out run inflation as bond yields move up. Granted, this assumes there is going to be inflation, which is a whole other argument. But if you'll grant us the assumption, we'll continue with the strategy...of finding assets that beat inflation.

You don't have to look far. Gold...oil...iron ore...tangible assets are what you're after. Does this conflict a bit with our analysis yesterday that China's resource demand is more fragile than reported? Yes, it does. But it still pays to focus on those resources that will be in demand no matter how bad the global economy gets again. What do nation states really want to own? What can they not do without?

You know they can't do without oil. And you know more and more of them prefer to own at least some gold rather than rapidly devaluing foreign currencies. That leaves us where we began, buying oil and gold and selling U.S. sovereign debt. Production of the first two is hard to increase. Supply of the last one is growing.

"There is a strong case to be made that we are already at 'peak gold'," Barrick's Aaron Regent told London's The Daily Telegraph today. Regent was speaking at RBC's annual gold conference in London. "Production peaked around 2000 and it has been in decline ever since, and we forecast that decline to continue. It is increasingly difficult to find ore."

Gold exploration budgets are up. But with the exception of China, gold production from traditional stalwarts like South Africa and Australia has trended down. Alex Cowie at Diggers and Drillers recently wrote a report suggesting that the best Aussie gold stories are listed here in Australia but digging for gold in Africa, where they incur production costs in U.S. dollars and where there are more greenfield projects than recycled brownfield projects.

Frankly, we have no idea if gold production has peaked. Mine supply could grow this year for all we know. But finding and mining gold is not easy and it's not cheap. And even if the gold supply does grow, we'd take it to the bank that the global gold supply will not grow faster than global money supply.

And oil? Any scenario in which an economic collapse leads to falling GDP ought to mean lower demand for oil and lower oil prices. But the case for oil is not really about the demand side. You reckon that's bound to grow over time anyway, unless someone comes up with table top cold fusion. The real oil bull story is on the supply side.

Earlier this week the U.K.'s Guardian reported that, "The world is much closer to running out of oil than official estimates admit, according to a whistleblower at the International Energy Agency who claims it has been deliberately underplaying a looming shortage for fear of triggering panic buying."

" 'The IEA in 2005 was predicting oil supplies could rise as high as 120m barrels a day by 2030 although it was forced to reduce this gradually to 116m and then 105m last year,' said the IEA source, who was unwilling to be identified for fear of reprisals inside the industry. 'The 120m figure always was nonsense but even today's number is much higher than can be justified and the IEA knows this.'"

We remember writing about the IEA figure a few years ago. And we remember pointing out that producing 120 million barrels of oil per day would be a 44% increase on producing 83 million barrels per day. And you'd have to find that oil first. You'd have to explore, drill, and produce it. And you'd have to maintain existing production levels at the world's big elephant fields like Cantarell and Ghawar.

In point of fact, production at Cantarell has fallen by 25% since 2004. Energy expert Matthew Simmons says Mexico's days as an oil exporter will end in 18 to 36 months. This makes Mexico's government-which derives 40% of its revenues from oil sales-the most likely candidate for "next failed state."

By the way, if you think illegal immigration is problem in America now (and it is), imagine what would happen if the finances of the Mexican state imploded with a production catastrophe at Cantarell. The Obama administration would face another crisis, but this one right on its massive southern border.

Not everyone believes in Peak Oil. But it's not really a matter of faith. Either oil production is declining or it is not. It does not mean there isn't any oil left. In fact, technology has lengthened the life of productive fields. And technology has also made it possible to find and produce oil in increasingly hostile environments (deep water drilling, the Arctic, etc.)

Even rank and file petroleum geologists are mostly in agreement (and sometimes in disagreement with their corporate overlords) that Peak Oil is real and it's here now. But we make this point not to say that all is lost. It isn't. It's just the great changes in the world are afoot.

You have a secular bond bull that's long in the tooth. The post-war monetary system that supported the expansion of the fiscal welfare state through perpetual debt is failing. Energy, which has been getting cheaper and cheaper for years as we found more and more of it, may start becoming more expensive and harder to find.

That's going to make the world a slightly less friendly place. But for investors, there are heaps of opportunities. For example, right now Alex is looking at what the fallout from next month's Copenhagen summit is. It has opened the door to a great entry point for energy investments, but not necessarily oil. Fear not! Or fear a little. But prepare.

Dan Denning
for The Daily Reckoning Australia

• Attack of the Bond Yields
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• U.S. Bond Prices Rose and Yields Fell
• Higher Oil Prices, the New Normal
• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis

First, Goldman's buy on the banks seemed to buoy the market. The Dow finished up 112 points and is just under 9,600. Meanwhile, Aussie stocks shrugged off that sense of impending doom and rallied 43 points yesterday. The ASX 200 is at 4,622 and thoughts of 5,000 by the end of the year must surely be dancing like sugarplums in the heads of some investors.

Ho! Ho! Ho!

But seriously. The banks? Really? Aren't you the least bit suspicious that Goldman is talking up the banks? Doesn't this mean Goldman is probably already short on the banks?

We have been hanging out at what we now call the "Trading Nebula" in our new offices. Our research department is growing, so we like to drop by and see what the traders think is happening. Often, it seems nebulous to us, given the peculiar vocabulary of indicators and charts the guys are using. Hence the "Trading Nebula."

But Murray Dawes was especially clear this morning when he told us that his screens are producing all sorts of warning signals on the banks. He is obviously running a different trading algorithm than Goldman. But then, he's producing trading leads for our new Slipstream Trader, which is designed to produce long and short ideas on ASX 200 stocks. In our chat this morning he told me that two banks showed up, although neither were part of the big four.

If Murray is suspicious that the banks can lead the market to higher highs, at least he's in good company. Bear heroine and noted financial analyst Meredith Whitney wrote in the Wall Street Journal over the weekend that, "Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting."

You don't say?

"Access to credit is being denied at an accelerating pace," Whitney adds. "Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan...In the U.S., small businesses employ 50 percent of the country's workforce and contribute 38 percent of GDP...Without access to credit, small businesses can't grow, can't hire, and too often end up going out of business."

What then, has the regulatory and policy reaction actually produced? It's propped up large institutions that still have heaps of bad assets and have used the last six months to increase their leverage. But at the regional and local level, real businesses with real customers and real capital needs can't get credit.

To summarise: We have saved the zombie companies with zombie assets at the expense of the living, breathing engine of the free market; the small business. This leads Whitney to conclude, that "We are only in the early stages of the second half of this credit cycle...I expect another $1.5 trillion of credit-card lines to be removed from the system by the end of 2010."

What will happen to the economy then? And what will happen to Australia then? Will it matter? The ability to extend credit to small businesses and households is concentrated in the hands of the Big Four. Does that make us safer? Or does it concentrate the risk in a few major players, jeopardising the whole system of credit?

What's clear is that the supply of commercial credit is more concentrated now than ever before. Will the Big Four shun risk and build a capital cushion by cutting off small business credit? Will they double down on their housing lending in order to support house prices; a scheme which supports the value of the assets the banks carry on their balance sheets?

If we're making it sound like the market and the economy are at a critical inflection point, it's because they are. The complacency of the last six months is giving way to some real questions about what to do with troubled assets that are still troubled and bad debts that are still bad. Can a global economy really grow when the financial system is weighed down by so much debt?

Professor Michael Hudson is coming to Australia and he says "No!" If you're interested in hearing what he has to say in person, check out his schedule here. You can RSVP for the event near you, provided seats are still available. If you can't make it, there's a good You Tube video of his ideas here.

We're not familiar with everything Dr. Hudson has to say. We're planning on catching up for lunch and will report back to you how it goes. In the meantime, he gave an interview with the folks over at Business Spectator and put his views lucidly: "There's a basic mathematical principle; a debt that can't be paid won't be paid."

Talking about the explosion in consumer debt world-wide, including here in Australia, Hudson says, "These debts are beyond people's ability to pay and so we're going to see breaks in the chain of payment and this means that a lot of debts are going to go bad. It means that people are going to hesitate to realise that they can't pay, a kind of cognitive diffidence [sic] that people have about the fact that they really can't pay their debts."

"They're willing to run down their savings, they're willing to sell off their assets and do everything, but in the end they default and this is what breaks the back of an economy. The houses are defaulted on, they're put up for sale, that crashes real estate prices all the more and, again, the commercial real estate is even in more serious condition than residential real estate right now."

Coming back to Barofsky and Goldman then, and if Hudson is right, is this the time to buy the banks? Barofsky's report concluded that not all nine of the banks that received $125 billion in capital infusions from the U.S. government here as "healthy" as Ben Bernanke and Hank Paulson made them out to be.

The nine institutions combined had over $11 trillion in assets. But Paulson made it sound as if the capital infusion would not only stabilise the banking sector, it would prompt the resumption of credit flows in the economy. That turned out to be...not true.

So what is the truth? Well, as we suggested at the time, the TARP was just a massive delaying tactic. The capital infusions (putting aside that it wasn't really capital but money the Federal government borrowed that must be repaid) were designed to prevent the banks from going insolvent on further asset write downs. But the whole logic of the deal was that asset values would stabilise and even improve, meaning the banks wouldn't have to take losses or raise more capital.

Give it time baby. Time heals all asset values, right?

No. It all goes back to what you mean by "troubled." And this is the real heart of the issue behind our mistrust of the stock market rally. There has been no real improvement in the quality of troubled assets in the last year. In fact, they are more troubled than ever. The financial system remains troubled, and not much in it has really changed.

This leaves the highly-leveraged banks in the same precarious position as they were before, albeit with slightly more confidence from a gullible public. But at the balance sheet level, have things really improved? And more importantly, have the trillions in assets in the financial system related to residential and commercial real estate really become more valuable in the last six months? Or is just a Ponzi Finance pyramid of junk waiting to go up in flames?

In our view, the last year has been a policy and regulatory sham to cover the retreat by bankers. The people heavily invested in the old system of debt-based asset appreciation are stalling for time. They hope that the passage of time will improve earnings for a quarter for two.

And if they are the religious sort, they pray that some other scheme will be established to take the troubled assets of their hands. But time cannot heal troubled asset values. Faith healing doesn't work in financial markets. We'd humbly suggest that the day of reckoning is still out there, hiding somewhere on the calendar, waiting to rise again. Until then...

Dan Denning
for The Daily Reckoning Australia

• Normally Small Businesses Lead the Economy Out of Recession
• Meredith Whitney and the Buy Recommendation on Goldman Sachs
• Rising in Defense of Goldman Sachs
• Warren Buffett is Buying Four Percent of Goldman Sachs
• Is the Macquarie Model Dead?

Your editor scratched his chin over this question while thumbing through a copy of the Financial Times over the weekend in the shadow of the le Grand Arche de la Defense west of Paris. You know the one. It's a modern, shiny, gleaming version of the Arch de la Triomphe.

Just why we chose to stay in the business district of Paris rather than down in the middle of the city...well it had to be a cost saving decision. It certainly wasn't aesthetic. This is Paris without the charm, pretty trees, and rich smelling coffee. In fact, with all the glass buildings and paved pathways, it could be any city anywhere during any credit boom. It's just another example of finance dominating the global economy.

And that returns us to the big question as we open the week. The financial markets have clearly rallied. If it's true that markets lead economies, markets are telling us that things are going to get much better. The FTSE index of emerging markets is up 99% from its March lows. The S&P 500 is up nearly 60%. And gold itself is up 25%, with much of that move coming in the last few weeks. This is what happened in 2003, all asset classes went up simultaneously, riding the global money tide.

David Rosenberg, who used to work at Merrill Lynch but is now the chief economist and strategist at Gluskin Sheff, says that something is fishy about this rally. It's come, at least in the U.S., as the economy lost another 2.5 million jobs. "Typically, by the time we are up 60%, the economy is well into the third year of recovery; we are not usually engaged in a debate as to what month the recession ended."

Fine, you may be thinking. Employment is a lagging indicator. It will be the last thing that picks up. But it will pick up. In the meantime, how can you ignore what the markets are saying?

One answer might be that the markets are rigged. Or, if that is too indelicate, you could say that the surge of liquidity provided by central banks has allowed banks to load up on assets again, producing paper gains which boosted earnings and justified-in the minds of some insane people-higher valuations for stocks. The bull is back baby! The economy should quite being such a party pooper and get with the program.

For example, during the same time that the U.S. economy has shrunk by about $400 billion in terms of GDP, the balance sheet of the Federal Reserve has grown by over $1 trillion. Japan has the same problem, a shrinking real economy and an expanding central bank balance sheet. GDP has fallen by £16 billion in the UK, but according the FT's Lex Column, the Bank of England has injected ten times that amount into the economy.

What does it all add up to? Why isn't an increase in credit leading to growth in the real economy? All that new money is not leading to a lending boom with renewed business investment that creates jobs and a recovery. Instead, it's leading to forced speculation in the stock market which is driving asset prices higher. This is the famous problem Alan Greenspan had with low interest rates. You can turn the credit spigot on, but you just never know where the money is going to flow.

Right now, it's flowing into stocks. Lex says that since Lehman collapsed, "US banks have increased their assets by 10 percent to $14.2 trillion." Rather than shrinking their balance sheets, the banks seem to have escaped the push for regulatory reform and actually loaded up again on free money for a credit-fuelled bender. Leverage is in vogue again, as are risk assets.

But we have no reason to believe this is going to end any differently than the last leveraged boom. We know how those end. We've seen bubbles popping steadily since 2000. First it was Internet and telecom stocks. Then emerging markets. Then common stocks. Then the commodities sector got pounded. And don't even get us started on how bad an investment sovereign government bonds issued by debtor countries are going to be.

All of that might sound unnecessarily grim for an Australian-based investor wandering the streets of Paris in late September. Can't we manage to say anything positive? Well....yes, we can! For example, last night's dinner of simple farm-style chicken in the shadow of the Sorbonne was...well it was excellent.

But what about investing? If you're going to have a plan for the next five years that takes into account this attempt to reflate the financial economy, there are a few things worth keeping in mind. First, it's going to fail, and probably spectacularly so. That failure will be accompanied by an even greater expansion of government debt.

For example, the Times of London is reporting that Britain's net debt is growing at a rate of nearly six thousand pounds per second. Tax receipts are plunging. And politicians, jack asses that they are, are actually making even more promises to deliver things they can't begin to pay for now.

We think they key idea in all of this is that you're going to witness a transfer of ownership in the underlying capital assets of the global economy. The big question is will you profit from it or be victimised by it? We reckon that if we're right-and if you can anticipate the general progression of events-you can stay one step ahead of the curve.

Easier said than done, right? So for the remainder of the week, we're going to go back and review our proposal for a "Permanent Portfolio." It will be based on a forecast of more debt deflation...and then rapid inflation.

Yes, it sounds tricky. But this isn't the first time this sort of thing has happened. Tomorrow, we'll take you back to one of the first "Great Inflations" Europe experienced and show you how it literally capitalised a new entrepreneurial class for the next three hundred years. Until then!

Dan Denning
for The Daily Reckoning Australia

• If Unemployment Numbers Get Better So Will the Economy
• The More Money in a Financial System the Less Each Unit is Worth
• Financial World Has Every Reason to Encourage Government Stimulus
• A Recovery of Some Kind in Global Trade
• Possible Second Round of Panic Hitting Financial Markets

"Since the global financial system started unraveling in dramatic fashion two years ago, distinguished economists have suffered a crisis of their own," starts the article. "Ivy League professors who had trumpeted the dawn of a new era of stability have scrambled to explain how, exactly, the worst financial crisis since the Great Depression had ambushed their entire profession.

"Amid the hand-wringing and the self-flagellation, a few more cerebral commentators started to speak about the arrival of a 'Minsky moment,' and a growing number of insiders began to warn of a coming 'Minsky meltdown.'

"'Minsky' was shorthand for Hyman Minsky, a hitherto obscure macroeconomist who died over a decade ago. Many economists had never heard of him when the crisis struck, and he remains a shadowy figure in the profession. But lately he has begun emerging as perhaps the most prescient big-picture thinker about what, exactly, we are going through.

"A contrarian amid the conformity of postwar America, an expert in the then-unfashionable subfields of finance and crisis, Minsky was one economist who saw what was coming. He predicted, decades ago, almost exactly the kind of meltdown that recently hammered the global economy."

Economists went off their heads in the last few decades. They thought capitalism would make us all rich. And they thought capitalism automatically tended toward beneficent equilibrium.

Here at The Daily Reckoning, intuitively, we guessed the contrary. The system produces a kind of orderly chaos...in which the rich are frequently impoverished, the proud are humbled...and the goofballs who think capitalism fails inevitably make things worse.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Nobody Appreciates Laissez-Faire Capitalism
• Depression: A Natural and Recurring Feature of Capitalism
• Gold Price Should Continue Going Up as the Dollar Accelerates its Terminal Decline
• Nobama rally… Nobama bounce… Nobama bull market… Nobama nuthin’…
• Capitalism and Capitalists

As for Tim Geithner, he takes no chances; he sings his own praises. Speaking to a gathering of the G20, he congratulated them all:

"...facing the greatest challenge to the world economy in generations, the G-20 gathered here in London and committed to an unprecedented program of policies to restore growth and reform the international financial system. Those actions have pulled the global economy back from the edge of the abyss. The financial system is showing signs of repair. Growth is now underway."

Stocks are still up. Commodities too. Oil is over $70. And most encouraging of all: the 10-year US Treasury note yields only 3.47%. So what evil sends investors running to the protection of gold? None at all, say the papers; investors buy gold in anticipation of better times. They see a recovery, bringing with it tightened supplies and rising demand. Every economist, investor and hair stylist knows what this means - inflation.

But if growth is underway, investors should be glad there is not more of it. The key indicators of real economic progress are negative. Unemployment is not rising; it is falling. Nearly 7 million Americans have lost their jobs since the recession began. In California, only 3 of 5 working age residents have a job. And those who are still working are putting in the shortest workweeks ever recorded. How could the economy be growing with fewer people earning money? The New York Times attempted to explain the enigma by calling it a "jobless recovery." But a recovery without jobs is like a loveless marriage or a fat-free burger - it is disappointing.

Another key indicator is personal spending. Not surprisingly, that is down too. Personal spending has fallen in four of the last six quarters - something that has never happened before, since they began keeping records in 1947. The level of consumer spending is down 33% from a year ago - with discretionary spending in the United States now down to a level it hasn't seen in 50 years. Consumers aren't spending partly because they have no money...and partly because they apply what money they have left to relieving the headache from their previous binge. A report this week showed they had reduced their hangover of personal debt in July by more than $21 billion - four times as much as economists forecast. These are, of course, the same economists who pimp for the angels at Bernanke & Co. If they're right, we have a spending- less, jobless recovery pushing up the price of gold.

We offer an alternate interpretation. We begin with a doubt about the one now on the table. In the popular version, the more the recovery seems real, the more investors fear real inflation. This drives them to buy gold. Of course, it should drive them to sell US Treasury bonds too - which hasn't happened. Nor has inflation gone up. And if this view were correct, we should begin to see remedial measures from the US central bank. The Fed should soon begin to withdraw its monetary stimulus, returning the economy to a kind of normalcy it hasn't seen in years. The risk, not insignificant, is that Fed economists will err. They may loosen monetary policy too slowly or too quickly. Asked about the risk, Janet Yellen, President of the Fed's San Francisco branch, promised to avoid the error of 1937 - she will not "tighten policy too soon, aborting the recovery."

Gold bulls are counting on her. And they may be right. But here on the back page, we add a nuance. We're not surprised by an occasional Fed error. What surprises us is the rare accidental success. There are 500 basis points between zero and 5%. It would take a miracle for central bankers to find exactly the rate the market needs precisely when it needs it most. The '37 error, for example, might have been a success. At least it sped up the process of liquidation so the decks were clear when the post-war boom finally came.

Maybe we'll get lucky and the Fed will make the same error again. Not likely. This time they'll make a different error - adding too much cash and too much credit for too long a time. Today's 'recovery' is based on hot money from the feds. It's a fake. It won't cause real growth. When this becomes clear, commodities will sink - along with stocks...and gold. Central banks, ignoring the futility of their hot money program so far, will add even more hot money. Eventually, the hot money will cause inflation to rise and gold to 'melt up.' Gold bulls will be proven more right than they imagine. But they may be proven wrong first.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Feds Want to Increase the Money Supply and Induce People to Spend Money
• Economy Has to Grow at 1% to Stay Even With Population Growth
• RBA Rate Cut Does Little to Unlock Credit Market
• Where, Exactly, is this Economy Headed?
• Feds’ Plan is to Reflate the Economy

The anniversary is the collapse of Lehman Brothers on September 15th 2008. It was like a financial "big bang," the end of one financial universe as we know it. But could there be more meteor strikes on the way for Planet Leveraged Earth? More on that issue below.

Slipping quietly under the radar in the build up to the Lehman anniversary is the fact that the All Ordinaries closed Friday at an 11-month high. Even a mediocre Friday session in New York will have to work to depress local shares. But it could happen.

In fact, our resident technical analyst and chartist Gabriel Andre told us last week that the S&P ASX 200 index had cleared (on the upside) the technically important 4,550 level. But he called this a "false breakout." The reason? None of his technical indicators have confirmed that there is any more momentum to the upside.

Of course, that doesn't mean the rally won't coast higher. We read from some analysts that there are still a lot of investors who are "underinvested" in stocks. But that hardly seems to be the problem at all. It's more like people are overinvested in an earnings growth story that's been fabricated from a mix of optimism and sleight of hand.

It will be a good test of Gabriel's new trading methodology. You may have seen last week that he's finally gone live with his "black box" method for finding trading patterns on ASX stocks. It's not a "black box" system, actually. Gabriel is simply testing the idea that you can capture price swings in blue chip prices using a combination of technical analysis and charting.

We will see if he's correct. It's an interesting proposition because it ignores things like the positive industrial output data from China that cheered Aussie investors last week. In fact, we reckon most technicians would be happy to chuck everything but a chart out the window when deciding to buy or sell. You don't eve n need a ticker symbol.

You just need a chart and some tools to analyse it in order to find the trading opportunity (long or short). We'll keep you posted on how it goes. We reckon there are a lot more opportunities on the short side than the long side. But they are opportunities none the less.

"Some day this war is gonna end," said Lt. Kilgore on the beach in Apocalypse Now. He was almost wistful about it, in the same way you read a lot of investment professionals talk about the collapse of Lehman Brothers last year. They're discussing it as it if were ancient history.

Not Joseph Stiglitz. The economist told Bloomberg that, "In the U.S. and many other countries, the too-big-to-fail banks have become even bigger...The problems are worse than they were in 2007 before the crisis." That does not sound promising. It sounds ominous, especially for banks and other financial stocks.

There certainly were a lot of casualties that resulted from Lehman's loss. Here in Australia the roll call of fallen firms includes Allco, Centro, Tricom, and ABC Learning. Some were killed in battle. Others were wounded and taken from the field. But is the war really over?

The press coverage would suggest that the war on the financial crisis-fought with unwieldy weapons like interest rates and fiscal policy by besuited warriors like Ben Bernanke and Wayne Swann - is not over, but not critical any longer either. It's as if the Germans have been pushed back east across the Rhine. Berlin hasn't been taken. But the beaches have been stormed and the Hun beaten back.

Yet if you examine the lessons of Lehman, you wonder if we have really learned anything. The collapse in global trade and output was the worse since World War Two, following the fall of Lehman. You can see it in quite shocking fashion from the chart below, courtesy of High Frequency Economics. But what does the chart actually mean?

The chart shows the first real and large fall in global trade since the 1970s. But we think it also shows that global output and trade have grown with the globalisation of fiat money. The entire global economy expanded at a furious pace because of the amount of credit and leverage in the global system.

When you take away this leverage - a process that began like hitting the proverbial brick wall with the Lehman collapse - you find that a lot of economic activity disappears once credit vanishes. The huge slump in output persists. But what's crazy is that stock prices began to recover once the free fall in output seemed to end in March.

Stocks seem to be repricing a return to growth rates, pre credit crisis. But as we've argued here before, most of the first and second quarter earnings outperformance for publicly listed stocks was driven by cost cutting and inventory destocking, not any fundamental improvement in business conditions.

Another lesson from Lehman was that asset prices (across all asset classes) were much more heavily supported by leverage than anyone suspected. This was true for commercial and residential real estate. It was true for stocks. It was true for commodities. And it was true for bonds.

In fact, we'd argue that it's only government-backed leverage that is supporting the U.S. bond market. You could even argue the rally in stocks was made possible by Fed-created liquidity, which banks and brokerages took advantage of to engineer a massive stock market rally which is now ending.

It's a mistake to think that letting Lehman collapse was only a mistake because Lehman proved to be so interconnected to the rest of the financial system. It wasn't just that Lehman was one of a handful of firms "too big to fail." This is the most under-appreciated point about the last two years.

The most important lesson from Lehman's collapse is that when you combine massive leverage with securitisation and derivitisation, you get a financial world that is inherently less stable. Statistically speaking, it's far more prone to volatility and collapse. The interconnectivity of the global economy showed how quickly instability could be transmitted across borders.

If you're a student of networks, this may seem counter intuitive. You might think that increasing the number of nodes in a network decreases instability. The more nodes and interconnections there are, the easier you'd think it would be for problem nodes (Lehman) to be bypassed or isolated before they can destabilise the whole system.

Yet it seems like the more complex the global financial system has become, the less stable it has become. hy is that? Maybe it's because there are several important connections we're talking about. For example, the fact that information and prices are communicated swiftly around the globe does not make the world economy less stable.

It may make trading more volatile as people try to figure out what news really matters. But the interconnectivity of the world has just upped the pace of business. It's forced everyone to have faster OODA loops (observe, orient, decide, act). So if sheer connectivity isn't to blame for instability, what is?

One likely culprit is complexity. We simply don't know how things are inter-related in the global economy. And by "things" we mean cross ownership of assets and obligations. What's made the system so unstable is that the asset side of the global balance sheet has become opaque. It's become derivative. It's become relative.

In the meantime, the liability side of the balance sheet grew and grew, setting up an inevitable "complexity catastrophe," to use Eric Beinhocker's term. As far as we can see, the complexity catastrophe is still unfolding as the value of bank collateral continues to deteriorate. Government's are trying to arrest the rate of decline to prevent massive unemployment, and meeting with some success.

But one year after Lehman, we feel confident in saying that someday this war is gonna end. But it's not today. And it won't be today for quite some time.

Dan Denning
for The Daily Reckoning Australia

• Technical Analysts see the Market 80% Psychological and 20% Logical
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• Financial World Has Every Reason to Encourage Government Stimulus

For the record, Roubini said, ""It has been widely reported today that I have stated that the recession will be over 'this year' and that I have 'improved' my economic outlook. Despite those reports - however - my views expressed today are no different than the views I have expressed previously. If anything my views were taken out of context."

"I have said on numerous occasions that the recession would last roughly 24 months. Therefore, we are 19 months into that recession. If as I predicted the recession is over by year end, it will have lasted 24 months with a recovery only beginning in 2010. Simply put I am not forecasting economic growth before year's end."

"Indeed, last year I argued that this will be a long and deep and protracted U-shaped recession that would last 24 months. Meanwhile, the consensus argued that this would be a short and shallow V-shaped 8 months long recession (like those in 1990-91 and 2001). That debate is over today as we are in the 19th month of a severe recession; so the V is out of the window and we are in a deep U-shaped recession. If that recession were to be over by year end - as I have consistently predicted - it would have lasted 24 months and thus been three times longer than the previous two and five times deeper - in terms of cumulative GDP contraction - than the previous two. So, there is nothing new in my remarks today about the recession being over at the end of this year.

"I have also consistently argued that there is a risk of a double-dip W-shaped recession toward the end of 2010, as a tough policy dilemma will emerge next year: on one side, early exit from monetary and fiscal easing would tip the economy into a new recession as the recovery is anaemic and deflationary pressures are dominant. On the other side, maintaining large budget deficits and continued monetization of such deficits would eventually increase long term interest rates (because of concerns about medium term fiscal sustainability and because of an increase in expected inflation) and thus would lead to a crowding out of private demand."

"While the recession will be over by the end of the year the recovery will be weak given the debt overhang in the household sector, the financial system and the corporate sector; and now there is also a massive re-leveraging of the public sector with unsustainable fiscal deficits and public debt accumulation."

"So, yes there is light at the end of the tunnel for the US and the global economy; but as I have consistently argued the recession will continue through the end of the year, and the recovery will be weak and at risk of a double dip, as the challenge of getting right the timing and size of the exit strategy for monetary and fiscal policy easing will be daunting.'

While Roubini is talking about exiting the strategy of easing fiscal policy, officials in China are warning that said policies may already have caused some danger in the form of risky lending in the real estate market. Hmm. That sounds familiar.

"Liu Mingkang, chairman of the China Banking Regulatory Commission, urged banks to guard against projects that have falsified or inadequate capital and risks in the real-estate market, according to a statement on the commission's website," reports today's Australian.

"Mr. Liu said banks should strictly follow criteria for granting loans on second mortgages.
Banks should also closely observe capital adequacy ratio standards and ensure the quality of loans, Mr. Liu said. The foundation for a sustained economic recovery was still not stable, Mr. Liu said, adding that the global financial situation was still fluctuating."

China's lending boom was instigated by its official monetary and fiscal policies and will end up causing a bubble in household debt, along with inflated real estate prices. But in the Western world-as Roubini pointed out-the household debt bubble is gradually migrating to the public sector, where deficits and debt are rising.

Australia's government debt and deficit levels as a percentage of GDP are still small compared to Japan, the U.S. and the U.K. But in a world with a capital crisis, even smaller deficits may be hard to fund. And maybe that's why the Australian Office of Financial Management is looking for back-door ways to tap your super.

The AOFM is working with the ASX to list government debt offerings so that you, the individual investor, can buy them as easily as you buy stocks. The AOFM reckons there's $30-$40 billon to be had in that market. And when you're selling around $700 million in debt once a week and $300 billion over the next three years, every little bit helps.

The AOFM's Chief Executive Neil Hyden told the Age, "We want to see whether we can expand the market for our bonds." That's probably a good idea, tapping domestic super annuation funds. Why?

Well, as we pointed out last week, the Aussie banks seem to have lost at least some of their appetite for snapping up government bond offerings. It's time for the government to find another creditor. This is the trouble when you become an endemic borrower. You always need a new fix, a new supplier.

"Ken Chapman, the ASX's general manager for new markets, said he would expect retail transactions would average $50,000 if government bonds were traded on the ASX. Mr. Chapman said government bonds would probably be attractive to investors nearing retirement age or already in retirement due to the security of the asset class. He said it would not be unreasonable to expect that 10 per cent of self-managed superannuation holdings - worth between $30 billion and $40 billion - would eventually buy government bonds through this system."

At least those who do have a self-managed super would be able to make the choice about how to allocate their assets. With nearly $400 billion in self managed super assets, it's not a small amount. But the bigger prize is setting up a retail government bond offering that super funds themselves can access, and invest in without their clients being any the wiser. More on super tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Roubini Says United States Will Climb Out of Recession Towards End of Year
• Fall in Commodity Prices Will Reduce Inflationary Forces
• Krugman Warns That the Run-up in Stocks Can’t Be Justified By the Fundamentals
• The BRIC’s Unite
• The Greenback and Gold Alliance

In the month of May, Japan's exports declined 40% year on year.

Yesterday came similar news from Europe. Industrial orders in the Eurozone dropped 35% in April, from the year before.

"Fed on hold as slump eases," reports The Wall Street Journal. What exactly is meant by 'slump eases' is unclear. As near as we can tell, the slump is getting worse.

"New home sales plunged 32.8%." Bloomberg reports that house prices in California and Las Vegas are being hit hard by a wave of foreclosed properties. Yes, dear reader, the anklebone is still connected to the leg bone.

Bloomberg also reports, "jobless claims are up."

A fellow loses his job; he can't pay his mortgage. The house goes onto the market and pushes down prices. Prices in California are off 30% year-to-year, with the median house at $267,000. In Las Vegas, the median house is only $135,000 with 75% of sold properties coming from foreclosures.

The housing market is slow. But it works like other markets. It reacts...then, it over-reacts. It shoots. Then, it over-shoots. One study we saw said that housing prices were now down to "reasonable" levels. But there's no law that says they can't go to unreasonable levels. They were very unreasonable two years ago; they're likely to be very unreasonable in the other direction before this depression is over. Hold on; maybe you'll be able to get the median house in California for $199,000.

The WSJ notices that the leg bone is connected to the knee bone too, "house price falls are cutting into economy," it says.

Well, what did you expect? That's what house price declines do. People feel poorer because they are poorer. And with no source of ready cash - they spend less. Then...the whole economy weakens...etc....etc.

We've been over that enough times already. You don't want to hear it again.

And remember how we warned of a big increase in credit card defaults? When the slump began...and consumers could no longer "take out equity" from their houses...they turned to credit cards to fill the gaps in household budgets. Since then, there has been no increase in household earnings. To the contrary, household earnings have gone down. So the fellow with more credit card debt and less revenue is in a predictable jam. What does he do? He defaults.

"Credit card delinquencies at record," says one headline.

"Credit card charge offs break record," says another.

And these aren't the only kind of defaults the United States will be bracing itself for. A second wave of mortgage loan defaults is headed this way. Batten down the hatches and otherwise prepare...once it hits these shores, it will likely do much more damage than the first wave.

Elsewhere in the news, we find GM closing plants and Ford cutting out half its suppliers.

Yes, the Fed is on hold. It dares not do anything else. Its voodoo revival program has not worked. The corpse of the real world economy is as lifeless as ever.

What will it do next? We wait to find out.

And poor Michael Jackson: RIP.

Bill Bonner
for The Daily Reckoning Australia

• Australian House Prices Are Severely and Seriously Unaffordable
• New Default Wave Hits Mortgage Industry
• California Has Run Out of Money
• House Prices Down and Aussie Market Enters Second Wave of Rebound Rally
• Australian Credit Card Debt Grew by 9% in February

It is possible that some event, such as the bankruptcy of General Motors may still precipitate a further decline. It would, indeed, be unusual for there to be no significant aftershocks following what may now be called the 2008 recession. Yet the rise in the global stock markets in the first half of 2009 has been substantial and reassuring. Investors will need to be careful, but are likely to feel that the greatest danger has probably passed. If so, they will want to invest in the opportunities that have been created by the recession itself.

Oil and gold prices have been linked for most of the period of the recession. In recent weeks, both have been in a stage of recovery. The gold price has reached $982 an ounce, close to its peak when it touched $1,000 an ounce. Oil prices fell in the recession by about 70 per cent, and have now received about 50 per cent.

The recovery in the gold price reflects a number of factors. The Asian economies have accumulated excessive quantities of dollar securities, and the Asian central banks are reluctant to continue accumulating dollars, except on a purely speculative basis. The weakening of the dollar has had a reciprocal effect in the strengthening of the gold price. There is also a fear that the Keynesian policies which have helped to create the appearance of a global recovery will, at some point, lead to a revival of inflation.

Angela Merkel has criticised the world's central bankers; she is afraid that their expansionist monetary policies could make the crisis worse. That lady is no Keynesian, but she is the Chancellor of Germany, which is Europe's leading economy. The European Union is the world's largest trading bloc. She has said that what these central banks have been doing "needs to be reversed. I am very sceptical about the extent of the Fed's actions and the way the Bank of England has carved its own little line in Europe." One does not have to agree with Chancellor Merkel to take notice of what she says. She is one of the world's most powerful politicians.

Underlying the rise in the oil price has been the basic strength of oil as a commodity. The world has probably reached the point at which oil supply has peaked - if not, we are close to that point. The growth of the huge economies of China and India is limited by the long term constraints of the oil supply, more than by any other factor.

If the recovery does continue, the oil price will regain the level of $100 a barrel, and the gold price will rise well above $1,000 an ounce. My own expectation is that these figures will be exceeded substantially, perhaps to $150 or $200 a barrel and $1,500 or $2,000 an ounce. But that will limit the possible global recovery. The world has, indeed, been living beyond its means, in terms of the oil supply. Everything else depends on that, and will have to adjust to a higher oil price.

William Rees-Mogg
for The Daily Reckoning Australia

• Housing and Unemployment Are Weaknesses in the U.S. Economy
• Gold and Oil are Acting as Though They Expect Higher Rates of Inflation
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• Exhausted Gold Shares
• Higher Oil Prices, the New Normal

The Dow rose again yesterday - up 101 points. Oil went up too - to $56. The dollar held steady. And gold was up again...to $911.

"Emerging market surge...Investors pile in on hopes of improved global economy," says the Financial Times.

And this from the Telegraph: "Recession 'over by Christmas,' says Fed chief Bernanke."

He did not say "Mission Accomplished." That phrase was used too recently by another high official. In that event, the mission turned out to be not as accomplished as he thought.

Will the government's War on Capitalism turn out better than their War on Terrorism? Or their War on Drugs? Or their War on Poverty?

"The last successful government program was WWII," said Jimmy Breslin. Since then, almost all of them have been useless or counterproductive. But year in and year out, they've given federal hacks more money and power.

The current War on Capitalism didn't begin a year ago, by the way. The feds have been conducting a dirty, undercover campaign against the free market for many years. Instead of permitting willing lenders and borrowers to set the price of credit, for example, the Federal Reserve imposed its own short-term rates many times over the last 50 years. Eleven times during that period, capitalism tried to correct the "borrow and spend" economy. Each time, the feds rushed in with more credit on even easier terms. By the recession of 2001-2002, the feds were intervening with such heavy hands that it set off the bubble in housing prices in the 2002-2007 period.

And when the bubble exploded, the fed's dirty campaign turned into a major war with huge pitched battles...and millions of casualties.

Bloomberg reported yesterday, "nearly a quarter of US homeowners are underwater." When the Fed flooded the market with so much easy credit, it pushed up housing prices way beyond what people could afford. Capitalism struck back - blowing up the dikes that held all that liquidity in place. But the explosion blew out the cushion of equity that kept homeowners afloat. House prices are still falling at a 14% annual rate. "Less than before," say the bulls. But still going down.

This has left some communities - such as Salinas, California - with as much as one-third of the housing stock worth less than the money owed against it.

And in Victorville, California, the bank decided it had too many foreclosed houses. An entire new development of 16 houses - some completed, with granite countertops and all...some incomplete - had been foreclosed. Squatters and vandals were making a mess of the place. So the bank demolished the lot of them.

And overstretched homeowners who have an "Alt-A" or "Option ARM" mortgage are in trouble come 2011...when the majority of these loans will reset at a higher rate. You think it was bad when the first wave of defaults hit the United States? This could have even more catastrophic consequences.

Today, the results of the stress test on banks are out. They show some banks in good shape. Others need more capital. Bank of America, for example, is said to need another $34 billion. Wells Fargo needs $15 billion. GMAC and Citi both need more cash.

But investors decided to look at the part of the glass that was full rather than the part that was empty. They pushed up financial sector stocks generally.

If capitalism had its way, it would sort out the banks quickly. Banks that couldn't raise the money they needed would go out of business. Their assets would be bought up by the solid banks. Life would go on.

But the feds' war against capitalism prevents this kind of simple resolution. Instead, weak, mismanaged institutions are kept alive with taxpayers' money.

"Trillions of dollars have been thrown at the system so that we can avoid the natural process of creative destruction," write Matthew Richardson and Nouriel Roubini in today's Financial Times.

Our next question: where is all this money going to come from?

Bill Bonner
for The Daily Reckoning Australia

• Free Market Capitalism, The God That Failed
• Capitalism Always Takes an Economy Where it Ought to Be
• Why Those Who Praise Capitalism Have So Little faith in It
• Stock Market Continues Its Recovery
• Capitalism is Inherently Unstable