Monday began with jitters over the market's reaction to a raise in the U.S. discount rate. In other words, the Federal Reserve increased the rate at which select banks can borrow from it.

The so called 'discount window', was intended to be an emergency lending facility. The lender of last resort. Instead, it's become the lender of any resort. The increase in the discount rate means it won't be as cheap to borrow money from the Fed.

The relevance to you shouldn't be underestimated. Aussie banks get much of their funding from overseas, so they are affected by what happens in the global interbank market. If the increase in the discount rate is a signal that the broader interest rate is going to be raised as well, then this would affect the availability of funds and their cost.

In a debt drugged, liquidity obsessed world, a change in interest rates can go from affecting profitability to affecting solvency very quickly. And it's not just the banks that are high on cheap credit. Take a look at a listed company's balance sheet. Most of them use leverage to boost their returns.

Low interest rates encourage this.

The reason the western world economy has become particularly interest rate sensitive is because of the way it uses debt. Instead of funding an asset with debt and then paying it off with the increased revenue, more debt is used to pay off the previous borrowings as they come due. This is referred to as rolling over debt.

By doing this, a company (or government) is able to sustain a high level of leverage over time. The debt is never truly repaid.

But, if interest rates rise, then the cost of borrowing goes up. Traditionally, this would have decreased the amount of borrowing. In our modern economy more must be borrowed in order to pay off the old debt. That means companies have no choice but to accept a change in rates.

The financial market reaction to a potential increase in the more important Fed Funds Rate would not have been pleasant. However, this unpleasantness didn't eventuate, indicating that financial markets expect rates to sit tight for some time to come. Based on this, Dan Denning is a step closer to declaring victory over our Money Morning editor Kris Sayce, with several beers at stake.

Neither editor is being suspicious enough in their analysis. Let's take a trip down memory lane with a former Federal Reserve economist, Michael Belongia. What happened in the past when the discount rate was changed?

In this podcast, Mr Belongia talks about how a change in the discount rate can lead to a change in the actual interest rate without FOMC approval, or much media attention. Going behind the back of the FOMC, which is supposed to set the interest rate, is scandalous. That didn't stop it from happening regularly, according the Belongia.

He explains that the spread between the discount rate and fed funds rate should be kept constant according to Fed policy. So, if the Fed's Board changes the discount rate, then the Fed Chairman can march down to the Fed's trading desk and instruct the traders to change the Fed Funds rate to maintain the spread. This conveniently avoids the often less complicit FOMC.

Belongia's accounts are shocking to anyone who believes in the integrity of that particular institution and sickening to the sensible people who don't.

As mentioned, governments around the world are also exposed to the problem of having to roll over debt. To Senator Joyce's delight, the lucky country is no exception. Dan Denning points out that "... according to 2008 data, over $400.1 billion dollars of Aussie foreign debt - or 35.4% of the total - matures in 90-days or less. Nearly half the debt total - $514 billion - matures in one year or less."

That's a lot of debt to refinance on such a regular basis, so any change in interest rates will be felt quickly.

The press often refers to the shortening maturity of government debts. This implies governments will have to roll over debt more often. Such shortening has occurred in the U.S. and is now a major concern. Former Federal Reserve Chairman Alan Greenspan has referred to it as the "critical Achilles heel".

The "greatest financial crisis globally ever"

On Tuesday, Bloomberg reported the confession of Kingpin Alan Greenspan. At least, we consider it a confession. Low interest rates have largely been blamed for the financial crisis by those who warned of its imminence. Greenspan set those rates artificially low. Often in a cunningly deceptive way, according to Mr Belongia. Anyway, here is how Greenspan's conscience was finally cleared on Bloomberg:

Former Federal Reserve Chairman Alan Greenspan said the financial crisis was "by far" the worst in history and called the recovery from the global recession "extremely unbalanced."

The world economy has undergone "by far the greatest financial crisis globally ever."

Greenspan said that while the economy was in worse shape in the Great Depression, the recent financial crisis was potentially more harmful than that in the 1930s because "never had short-term credit literally withdrawn."

Greenspan also said "fiscal affairs are threatening this outlook" for recovery, as Congress and the White House face difficulty raising taxes or cutting spending."

So, not only is his reconciliation late, but his diagnosis is too.

Speaking of confessions, our other 'favourite' economist, former Enron adviser and Nobel Laureate Paul Krugman, has declared his ignorance publicly:

"I'm craving the chance to do some deep thinking, and I haven't been doing a lot of that."

While this fact is familiar to most, it does not excuse Krugman's behaviour. Having consistently advocated the inflation of economic bubbles, to the devastation of homeowners, employees and shareholders around the world, he now advocates a level of government debt that would make Senator Joyce faint, or pop, whichever comes first.

But best of all is this part of Krugman's article:

"I guess doing the really creative academic work does require a state of mind that's hard to maintain throughout your whole life."

Creativity! Economics and creativity? Economics is about understanding timeless principles. Perhaps this is where he went wrong - too much creativity. We have seen the results of Krugman's creative solutions, indicating he doesn't understand the economy, or wishes to indebt future generations beyond help.

Resources Comeback

RBA governor Rick Battelino explained that the resources boom has overcome an interruption known as the GFC:

... now that has passed, the underlying dynamics of the resource boom are starting to reappear...

It's hard to put a finger on exactly how much investment is going to take place, but I don't think it's unreasonable to expect mining investments to rise to 6 per cent of GDP over the next few years. That would be about twice as high as it got to in the previous boom. It's a very big boom.

It certainly is big. But so are China's resource reserves.

In an article on oilprice.com, Dave Forest of the e-letter Pierce Points, warns of the potential price reaction should China decide to begin using those reserves, or even selling them. In fact, they may have already started, with vast steel exports going to Europe.

The effect a short term fall in commodity prices could have on Aussie resource investment and development could be pivotal to the future of the Australian economy.

China itself is of course an economic basket case, as cleverly shown in this business spectator slideshow.

Nevertheless, it seems a BRIC barbeque is roasting the PIIGS and may provide demand for resources to fuel their fire. (Thanks to Daily Reckoning reader Wayne for the inspiration on that one!)

Confidence

Confidence indicators took a hit in the U.S. and Germany, while U.S. new home sales dropped to a record low. This is particularly striking, as central banks often tout these two factors as their primary focus. "Restoring confidence in the market" and "supporting house prices" are phrases that echo through the halls of the central banks on a continuous basis.

Meanwhile, the US unemployment figures are proving disastrous, let alone the unemployment itself. The American Bureau of Labour Statistics has its own numbers in such a mess that the pollster Gallup has decided to help out.

The Poll informed the BLS that "nearly 20 percent [of the 20,000 adults in the work force polled] were working part time in January because they couldn't find a full-time job or had no work at all, and that they are having trouble affording basic necessities like food, shelter and health care."

This tells a different story from the BLS estimates of below 10% unemployment.

U.S. banks continue their slide into oblivion, with 4 of the 161 bank failures since 2009 recorded last week. The outlook isn't much better. Bloomberg reports that "hundreds of banks may face insolvency as losses mount on commercial real-estate loans, according to a Feb. 10 report by the panel appointed by Congress to oversee the U.S. bailout program."

Meanwhile The Telegraph uses some spectacular phrases in an article titled "Failure to save East Europe will lead to worldwide meltdown". It even breaks the language barrier with the following: "...set off round two of our financial Götterdämmerung." Götterdämmerung roughly translates to Godly twilight, implying an age of saviourless darkness.

Next up it suggests a "Monetary Stalingrad" and Eastern Europe "blowing up right now." A more surgical approach was taken by Latvia's central bank governor, who declared the Latvian economy "clinically dead", while protesters "trashed the treasury and stormed parliament."

Needless to say, an excellent article.

Strangely enough, stock markets remain comparatively buoyant and Australia seems to be trundling along happily. Whether Mr Market has sucked in enough suckers before another crash is unclear. Daily Reckoning editors would probably be more concerned if the media was more optimistic, as this indicates complacency.

The Economic Climate

Former IMF economist Jeffrey Sachs provided some creativity of his own in a recent article:

Climate change science is a wondrous intellectual activity. Great scientific minds have learned over the course of many decades to "read" the Earth's history, in order to understand how the climate system works. They have deployed brilliant physics, biology, and instrumentation (such as satellites reading detailed features of the Earth's systems) in order to advance our understanding.

The Guardian, points out otherwise:

Scientists have been forced to withdraw a study on projected sea level rise due to global warming after finding mistakes that undermined the findings.

This article was previously put forward as proof of claims made in the infamous IPCC report. The official withdrawal included the statement that "... it's one of those things that happens. People make mistakes and mistakes happen in science."

While we are in agreement that mistakes happen, we do not agree that government policy should be based on anything quite so mistaken. This is especially so, as government policy is more often than not an inherent mistake as well.

In keeping with brilliantly balanced and fair journalism, the Guardian published the article of Jeffrey Sachs two days before the article about the withdrawal of the study. I wonder what readers think of that.

In the name of financial stability!

Dan Denning also reported on the latest government scheme to support its funding aspirations:

Yesterday's Financial Review even mentioned the possibility that a shrinking government bond market would be a problem for Australian banks. That's because a new regulation proposed by the Australian Prudential Regulatory Authority (APRA) would require a certain percentage of bank assets to be made up of high credit quality bonds. And MBS.

MBSs are Mortgage Backed Securities, those things that have a habit of blowing up when house prices fall.

Acropolis Now

According to Porter Stansberry, the publisher of Stansberry and Associates Investment Research, the Greeks have pulled off a feat that would make Sun Tzu jealous. Greek military spending has been excluded from the annual budget, because it is a "state secret". So, according to Stansberry, about 30% of the Greek governments' spending isn't even declared.

Nickolai Hubble
The Daily Reckoning Week in Review

• Hike in Fed Funds Rate Would Cause Damage to Collateral on Books of America’s Banks
• Gold Standard Doubles as the Greenspan Fed Makes Real Interest Rates Negative
• Alan Greenspan Bears Blame for Intensity of Financial Crisis
• Alan Greenspan’s “Smallish” Injections
• Federal Reserve to Withdraw its Support of U.S. Mortgage Market?

Outside Australia, all eyes are on Greece. According to Bloomberg, Germany and France want the Greek government to make concrete budget cuts before organising a bailout. Of course it's not just the Greeks that have a lot to lose if a deal isn't found. A lot of bondholders (banks) will lose too.

But the biggest loser of all is Europe's common currency itself. Monetary union in Europe was always an experiment. It got rid of all the old colourful paper currencies in Europe and replaced them with impressive looking new paper notes. It also made the euro a reserve currency to rival the dollar.

It now looks, though, like Europe's experiment with paper money may go up flames even faster than the U.S. dollar, which is an impressive achievement. Twelve economies, one interest rate policy, high government deficits as a matter of course....it's a mess. It makes high-yielding commodity currencies like the Aussie dollar and the Canadian loony look downright sexy.

One perverse irony of the Euros woes is that it might be good for the U.S. dollar. Still, the bond markets are telling us that the world is fed up (or over-fed) with U.S. debts. Dow Jones newswires reports that an auction of $25 billion in 10-year U.S. notes "did not go particularly well." It doesn't bode "particularly well" for an auction of $16 billion in thirty year bonds set for later this week.

Even though the 10-year auction was over-subscribed, this kind of action suggests higher yields (borrowing costs) ahead. That's an ominous sign if you have or plan to have large structural deficits. It's also a bad sign given that the Fed hasn't even begun its "exit strategy" from the bond markets. It's still supporting prices and suppressing yields.

If the mere indication that it's going to exit the market lessens demand for Treasuries, what will it's actual exit do? Come to think of it, what will happen when the Fed stops buying and the Chinese start selling? We reckon the Fed will have to a quick about face. More on that in second.

Further to yesterday's point about debt as a very bad habit, check out the chart below. It shows the large spike in gross and net interest paid to Australia's overseas creditors. By today's standards, paying out $30 billion in interest to your creditors (half of whom are in the U.S. and the U.K)seems like a fairly small price to pay for such an extravagant increase in house prices across the nation.

Just one small point, though. According the date, 37% of Australia's debt is denominated in Aussie dollars and 39% of it matures in 90 days or less. This makes the debt sensitive to exchange rates and extremely interest rate sensitive too. A spike in rates and/or a fall in the Aussie dollar makes paying back and servicing the debt much more expensive.

Perhaps this is one reason CBA is keeping more of its cash.

In any event, the net interest on the debt doesn't look back-breaking at these levels. But if the debt continues to accumulate or interest rates rise, it does start to get heavier. And at bottom is a simple financial point: interest paid on your borrowings doesn't increase your capital. It's just money sucked into a giant black hole.

You had better hope the capital goods or investments you made with your money compensate you for the cost of servicing your debts. In Australia's case, that means the country needs higher and higher house prices. By the way, the ABS reported yesterday that housing finance approvals fell by 5.5%. The question is begged: when housing finance slows down, will housing prices follow?

Yesterday we claimed that borrowing your way to national prosperity is a sure-fire way to servitude and political instability. Today, we aim to prove it. To do so, we cite this article from Reuters. It suggests that China is using or should use its large holdings of U.S. Treasury bonds as a cudgel with which to bludgeon the United States its strategic adversary/ indispensable economic partner.

Figures in the People's Liberation Army want the financiers to sell U.S. bonds as a way of punishing Washington for selling arms to Taiwan. Mind you this might not seem like such a good idea if the bond selling triggers a run on the dollar and swift devaluation in China's forex reserves. But maybe China's arsenal of U.S. bonds is a like a pile of bullets - they're no good unless you fire them.

Of course what we're suggesting is that China accumulated U.S. debt as both a by-product and a weapon. The huge stock of U.S. government securities was by product of China's trade strategy. That strategy was to keep its currency low and gain global manufacturing market share through low labour and production costs. The result was a blizzard of U.S. dollar trade surpluses that were reinvested into U.S. bonds.

You could say it's China that's paid for the wars in Afghanistan and Iraq.

But why is this bundle of bonds now a weapon? We think China's export-driven growth strategy is on its last legs. Labour unions in Europe and America given today's political climate and high unemployment - will have the ear of politicians. And they will be saying something like this, "Make the Chinese pay!"

What they'll mean is that China will be pressured to give up its main economic weapon - currency manipulation. This has kept Chinese exports cheap all over the world and led to the gutting of American manufacturing jobs. It's made it pretty tough on exporters in Europe too. As a result of China's dollar peg, European exporters suffered doubly from a weaker U.S. dollar. American goods were cheaper in Europe. But European goods were not cheaper in China.

So the unions and the politicians will probably not tolerate another leg of the global recession in which China gains more market share by keeping the currency peg and exporting its way to more growth (if growth is to be had). It brings us to the end-game of China's export-driven development.

It also brings us back to one of the great monetary questions of the day: when will China de-peg? The answer has always been simple: when it is in China's interests to do. To us, that means China will de-peg when the benefits of increased purchasing power in the currency are more important that dwindling export profits.

In other words, we think China is close to a new phase of growth that's driven by consumer demand, domestic consumption, and more mature Chinese capital markets open to foreign investment. A de-pegging of the currency would see a much stronger Yuan. This would give Chinese savers a lot of spending power on global markets. They would also be able to buy more Chinese goods, which might lead to higher wages in China too (and more stoking of consumer demand).

This is all a theory, of course. And we could be way wrong. But there will come a day when Chinese customers are worth more to Chinese producers than American customers. De-pegging the currency will bring that day forward. And it could be sooner than you think.

This means that the accumulation of forex reserves was never really meant to protect China from external trade shocks, although they would be handy in that event. It means they were a side effect of a trade strategy whose ultimate objective was to gain as much global manufacturing market share as possible.

Now, you might wonder why China would damage its own interests by "punishing" the United States and selling bonds. But it depends on what China's interests are. If China's interests are in fundamentally weakening an economic competitor and strategic adversary, then selling U.S. bonds is in China's interests.

China's ultimate interests are in regaining Taiwan. And we'd suggest it try and use its bond leverage to weaken U.S. resolve about defending Taiwan. And selling U.S. bonds or crashing the dollar wouldn't just weaken U.S. resolve. It would expose the loss of strategic influence that occurs when you are a chronic debtor nation.

Mind you the U.S. still has a lot of aircraft carriers, strategic bombers, and nuclear weapons. It's not like its bereft of tools of persuasion. But the basis of all those tools has always been a strong economy, a strong industrial base, and sound finances.

The question now is, if the base of military strength has been eroded, how long will the U.S. maintain its military advantage? Can America afford it? And when push comes to shove, will American voters demand that an American President defend Taiwan? Hmmn.

Dan Denning
for The Daily Reckoning Australia

• The Chinese and the Fed Both Buying U.S. Treasury Bonds
• David Murray Says You Become Dependent on Global Banks When Importing Capital
• China Continuing to Buy US Bonds “Every Day”
• China Performs a Kind of Financial Alchemy
• China Reduces Holdings of Treasury Securities

There is a risk in holding cash in an environment of asset price inflation - a condition that usually occurs when governments create large fiscal deficits and inflate the money supply. The practice is endemic to banana republics and declining empires...and it is happening in the US at this very moment.

The global recession and financial crisis have refocused attention on government stimulus packages. These packages typically emphasize spending, predicated on the view that the expenditure 'multipliers' are greater than one - so that gross domestic product expands by more than government spending itself. Stimulus packages typically also feature tax reductions, designed partly to boost consumer demand (by raising disposable income) and partly to stimulate work effort, production and investment (by lowering rates).

The existing empirical evidence on the response of real gross domestic product to added government spending and tax changes is thin... But the evidence is quite strong that these policy responses usually trigger inflation.

I suppose that even someone without any common sense might understand that a "strong currency" over longer periods of time reflects a high degree of prosperity and economic success, whereas a chronically weak currency is symptomatic of economic imbalances, such as a lack of competitiveness or overconsumption, arising usually from excessive supply of money and credit.

I would also suppose that even if someone never travels overseas, he would understand that if the US dollar loses 50% of its value against all the other world currencies (everything else being equal), it means the US is 50% poorer relative to the rest of the world. (Now, this is not entirely correct, since the US has overseas assets that would appreciate in value in USD terms).

Moreover, stock price movements become extremely volatile and erratic in countries with a depreciating currency. In the long run, the depreciation of the currency will usually more than eliminate the gains in local currency terms. So, whereas in 2007 both the Dow Jones and the S&P 500 exceeded their previous highs reached in 2000 in US dollar terms, these indices failed to make new highs in Euro terms. In addition, whereas the US economy expanded in US dollar terms between 2001 and 2007, in Euro terms it actually contracted!

Even with the S&P 500 having shot up since the beginning of the year by over 25%, it has merely kept pace with the price of gold. And during the last 10 years, the S&P has lagged behind the official US inflation rate...while lagging VERY far behind both the euro and gold. Since the end of 1999, the S&P 500 has delivered a total return after inflation of about MINUS 25%.

Unfortunately, the US is not the only country that is busily debasing its currency. "Everyone" is doing it. Because of the current collective debasement of all paper currencies by central bankers, I believe that precious metals and mining companies will maintain their purchasing power.

In the 1980s the US dollar was a very strong paper currency compared to the Mexican Peso. Today, there is no paper currency that is as strong relative to the US dollar as the US dollar was relative to the Peso in the 1980s! The only "currencies" that have a chance of becoming as strong against the US dollar as the US dollar was against the Peso between 1979 and 1988 are precious metals such as gold, silver, platinum, and palladium.

Also, I should add that precious metals could appreciate even if the US dollar miraculously recovered strongly against foreign currencies for an extended period of time. Such dollar strength would probably be a symptom of some horrible economic or political problems around the world, which could be friendly to precious metals.

Central bankers and pundits seem to believe that they have averted the second Great Depression, while ignoring the fact that more and more debt produces less and less GDP and fewer and fewer jobs.

For now, though, the low ten-year bond yield is the lifeline from which all support flows. Much of the investment universe holds together because money can still be had for cheap - not by the volition of a cooperative private sector, rather induced by a US government that simply distributes money for free. Such an ill-conceived idea could only have been born in the test tube of a central banker.

Private lenders comprehend the difficulty of making profits when being forced to lend for nothing, so the government increasingly finds itself to be the interest-free lender of last resort.

Ultimately, if central bankers continue this process for long enough, it is the dollar, and any currency or economy still pegged to it, that could eventually crash. Therefore, we investors find ourselves in the precarious position of having to maintain sufficient liquidity, but not too much in case the real value of these liquid reserves is wiped out by politicians and central bankers gone mad.

Regards,

Dr. Marc Faber
for The Daily Reckoning Australia

• US Dollar As Reserve Currency Not Working Very Well
• 4 Ways to Protect Against a Falling Dollar
• Is Gold Money?
• Gold Falls for Four Straight Days but is the Low Price a Bad Thing?
• Transfer of Wealth

According to the US Department of Energy, liquid fuel demand in the developed nations peaked in August 2005 at 41.89 million barrels per day. Since then, it has plunged by 3.6 million barrels per day to 38.27 million barrels per day. However, you may want to note that despite these tough economic conditions, consumption has been extremely resilient in the emerging world. For instance, demand in the developing countries peaked in October 2008 at 46.33 million barrels per day and it is down by only 0.36 million barrels per day! I am amazed that the worst global recession in decades has barely managed to shrink energy demand in the developing world. Whilst this is wonderful news for the energy investor, it is a terrible sign for society.

At present, our world is using up roughly 84 million barrels of liquid fuels per day and for the moment at least, there is sufficient supply to meet demand (Figure 1). However, when economic activity picks up, it won't take much for demand to zip right past supply. Remember, it is much easier to increase usage, but it takes a long time to ramp up production. So, unless this is a permanent global recession (which I doubt), it is inevitable that the price of oil will go up significantly over the medium to long-term.

On the supply side of the equation, let me be clear. If I was asked to pick the biggest threat to a sustainable economic recovery, Peak Oil would top that list. Remember, Peak Oil doesn't mean that we are running out of oil reserves, crude will be around for decades. However, 'Peak Oil' does imply that we are dangerously close to peak global oil production. 'Peak Oil' also means that rather than experiencing a burst in oil supplies as many expect, from here onwards, we will witness sharp declines in global flow rates. In a nutshell, the era of cheap energy is over and the price of crude oil will rocket higher over the
coming decade.

Now, many skeptics will argue that if Peak Oil was real, the price of oil wouldn't have dropped to roughly US$30 per barrel in last autumn's stunning crash. Valid point; but let us not forget that the spectacular plunge occurred at a time when global economic activity virtually came to a standstill. Let us also keep in mind that last autumn's crash in asset prices was caused by a total freeze in credit and the associated asset liquidation. Whilst I agree that the final action in crude oil's parabolic blow-off last July smacked of speculation, I can assure you that speculation alone couldn't have created a multi-year boom whereby the price of crude oil went up by almost 1500%! As you can see from Figure 1 above, supply clearly fell short of demand between 2005 and 2008, and this is why we had a magnificent bull-market in crude oil.

Make no mistake, global demand for liquid fuels will rise again - and if my homework is correct, supply won't be able to keep up. If you ignore the noise and review hard data, you will observe that the vast majority of the world's most prolific oil provinces are now past peak production and in a state of permanent depletion. According to the BP Statistical Review of World Energy, out of the 54 oil producing nations and regions in the world, only 14 are still increasing production. Alarmingly, 30 oil producing nations and regions are definitely past their peak output and the remaining 10 appear to have modestly declining production rates. Put another way, when weighted by production, Peak Oil is already a grim reality in 61% of the oil producing world!

Still not convinced about Peak Oil? Then review Figure 2, which charts the expected combined flow rates for crude oil, lease condensates and Canadian Oil Sands. As you can see from the grey shaded area, production is about to decline by roughly 5 million barrels per day by 2012.

Ironically, Figure 2 also plots the optimistic (almost laughable) forecast made by the International Energy Agency (IEA) in its "World Energy Outlook 2008". Interestingly, in last year's "World Energy Outlook", the IEA stated that in order to fulfill its optimistic projections, the world had to install 64 million barrels per day of new supply by 2030 or the equivalent of six times the Saudi Arabian output! Furthermore, the IEA declared that the energy industry had to invest hundreds of billions of dollars every year to achieve this favorable outcome.

Now, I can understand that the IEA is a government-funded agency so it has to paint a rosy picture, but it is ominous that the energy watchdog failed to mention where this surplus oil would come from!

Well, I guess you get the idea. Global crude oil production has probably peaked, new discoveries have dried up and there is a shortage of capital for investment purposes. Apart from these factors, if you believe the energy optimists, all is well in the energy industry and the price of oil is about to drop to zero!

After years of extensive research, I have no doubt in my mind that unless global demand stays weak forever, we will see supply shortages in the not too distant future. And before that occurs, the price of crude oil will stage an explosive rally. Accordingly, I suggest that all my readers allocate a large proportion of their investment portfolio to upstream energy companies and to businesses in the energy services sector.

Finally, in the energy complex, the price of natural gas is still scraping along its recent crash low and this is a fantastic long-term investment opportunity. As we approach winter in the Northern Hemisphere and heating demand picks up, we are likely to see a big rally in the price of natural gas. So, investors may want to allocate capital to this unbelievably inexpensive commodity.

Regards,

Puru Saxena
for The Daily Reckoning Australia

• Supply of Conventional Crude Oil is Very Close to its Peak
• Pemex and Mexican Peak Oil Equal Expensive Oil
• Peak Oil – The Rewards
• Peak Oil – The Risks
• International Energy Agency Rejects Possibility Crude Oil Output is in Terminal Decline

Are Australian banks going to be able to sustain their dividends? Over the last ten years, bank fee income has become a big driver of bank profitability (and the source of the dividends paid by banks). The credit crunch has crunched the amount of money banks make lending money. The net interest margin - the difference between what Aussie banks pay to borrow from overseas and what they make lending domestically - has been shrinking.

Here's a question then...if the bank's cut their fees, are they cutting off their own heads? For example, NAB is axing its penalty fees for overdrawn accounts. A Reserve Bank study published in May showed that so-called "exception fees" resulted in $1.2 billion in fee charges to Aussie households - or 10.34% of total bank fee income for the year.

Total domestic bank fee income for Aussie banks was up 8% last year to $11.6 billion. You can see from the chart below that fee income has been growing by about 11% the last few years. But keep in mind that aggregate profits of the Big Four banks last year were $15.9 billion. That means fees accounted for nearly 73% of total bank profits, according to our back-of-the-envelope math.

This actually shows you how bad a business banking typically should be. You can only make money lending money by taking more risk (both as a borrower on international capital markets and a lender on the domestic residential real estate market). If you take less risk, you have to make up for the fall in income by raising fees, which infuriates customers and law makers. Banking isn't a low margin business. But maybe it's headed that way.

Speaking of cash, should BHP sending more cash to share holders? That's the question some investors are beginning to ask, according to Bloomberg. Our co-Melbourne based commodity giant told investors that its record of seven consecutive profit results has ended. Underlying full-year profit for 2009 was down 30% to $12.8 billion on the back of lower commodity prices and demand in the fiscal year.

But the company left its dividend in line with the second half of last year at US 41 cents per share. It did not increase the dividend. However that dividend is 17.1% larger than the year before. So why not give back more cash to investors?

Mining is a capital-intensive business. BHP has been around the commodity block a few times. It knows that to expand production when commodity demand picks up requires cash. You have to keep that cash around for a rainy day for when the cycle turns.

Or, conversely, if the cycle turns down again - as it might if the global recession takes a second, depressionary dip - the cash is a bulwark against weak demand. It's also nice to have a war-chest to buy out asset-rich, cash-poor firms that cannot ride out a sustained drought in earnings when production is shuttered. BHP remains in a better capital position than nearly all its global rivals.

But if you don't want to put your capital risk in common stock, why not have a look at the new inflation-indexed bonds being issued by the Federal government for the first time in six years? Yesterday's Age reports that the Australian Office of Financial Management plans to introduce the bonds back to the market in September or October of next year.

Finding assets that deliver a return greater than the rate of inflation is going to be the big challenge in the years ahead. Inflation-indexed bonds are one strategy. Small cap growth stocks are another (especially precious metals and energy stocks leveraged to higher gold and oil prices). Emerging markets are a third. We'll ask the Australian Wealth Gameplan editor what he thinks of these bonds and get back to you tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• Note to Australia: Buy Resources, Not Banks
• Aussie Banks Addicted to Foreign Borrowing
• One in Four US banks Announce Unprofitable Quarter

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
• Does Gold Do Anything But Rise?
• Gold and Oil are Acting as Though They Expect Higher Rates of Inflation
• The Rally is On as the Dow Rises
• Exhausted Gold Shares

On the other hand, while we're looking for signs that stocks might rally on an oil price decline, some people are predicting Financial Armageddon. That's more our style.

Yesterday at the Old Hat Factory we had a discussion about Freddie Krueger and whether or not he is modeled on the Sandman. Freddie, you might remember, is the villain from the movie "Nightmare on Elm Street." He is, apparently, haunting the dreams of equity strategist Albert Edwards at Societe General.

Edwards send a note to clients this week that could give even the most dedicated bear insomnia. "Even as structural bears on equities over the last decade, we have never felt the confidence to lower equities to a minimum possible exposure of 30%. That ends today," he wrote.

"It is the first time in over a decade that we have felt so very strongly that we make this recommendation. Conversely, as the world frets about inflation we raise our government bond weighting to its maximum 50%. We are not through the worst of this crisis. The worst is still to come."

But wait.

There's more.

"We are trying to give our readers the strongest possible warning (ever!) that we are on the cusp of an equity meltdown that will slash and shred portfolios like Freddie Krueger. We see a global recession unfolding. Nowhere and nothing will be immune."

You have to give the man credit for being pretty unambiguous. So many financial calls these days try to have it both ways, hedging a prediction with a caveat, qualified by a proviso.

Here's a question, though. If you really believe the worst is still to come and that portfolios will be shredded and slashed "like Freddie Krueger" why would you have 30% of your portfolio in shares at all? Why not 50% cash and 50% bonds? Or 50% bonds, 30% cash, 20% precious metals, and 10% precious metals shares... or some such combination?

We won't quibble with Edwards. Investors have consistently underestimated the seriousness of a long-term bear market in credit. The flip side to the scenario we mentioned yesterday is that the S&P 500 does NOT break out of its down trend, that high oil prices and higher inflation coexist side by side, and that financial stocks continue to write down asset values.

Wikipedia describes Freddie as the, "undead serial killer... who attacks victim from within their own dreams." That sounds just like the credit crisis. Undead mortgage loans attacking commercial and investment banks from within their own balance sheets.

BHP has taken a break from being pursued by China to become a pursuer. The company agreed to buy Canadian firm Anglo Potash for $300 million. Potash is the latest commodity to get swept up in the food crisis. It's an ingredient in fertilizer, something you need to grow food for a planet with over six billion people.

Speaking of inflation, China's inflation rate reached a 12-year high of 8.3% in March. Food prices (remember potash) were up 22%. China's central bank responded by trying to cool lending activity. It raised reserve requirements at banks to 16.5%

China is a rocking-chair economy. Politically, the leaders of its economy value stability. But social stability only comes with economic growth (as Bill mentions below). Growth with stability is like a rocking chair, moving and staying put at the same time. Rock too fast, though, and things fall apart.

Dan Denning
The Daily Reckoning Australia

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• Fannie Mae and Freddie Mac Investors Have Already Lost 80% of Their Money
• Fannie and Freddie are Finito