As the ill-effects of a global financial crisis became evident to world leaders in late fall 2008, export driven economies with surplussed coffers of U.S. dollars did the obvious. They used the cash to stimulate their economies. In one specific nation, the Premier’s words fell like heavy boots on an ant hill, as decrees began to waterfall down from superiors to the next in command. Calls for growth began reverberating through the ranks of the quasi-communist Eastern leader, as China’s Communist Party (CCP), headed by Wen Jiabao, deployed a two pronged stimulus in the People’s Republic of China (PRC).

Step one was to simply spend a tangible magnitude of cash, $600 billion USD worth of yuan, equal to 13% of 2008 GDP. The spending was mainly split between direct investment in infrastructure and financial assistance to consumers through rebates and vouchers for consumer purchases of specifically targeted industry goods. Step two came in the form of quantitative easing, where governors set record low interest rates and lax loan requirements with PRC guarantees to back the underwriting. This pure recipe for growth has worked in the short term as real estate appraisals in the gentrified sister state of Hong Kong are 30% higher than last year, and China’s money supply rose by 27.7% in 2009.

At face value China’s economy saw GDP growth above 10% in 2009. Until recently, asset bubble fears in China have been footnotes to the apparent success of the country, as global equity markets have recovered. Unfortunately, it is the activity on the ground floor of the public sector that may house discrete risks facing China’s recovery. Public finance in China has for years been a troubling issue among academics in World Bank discussions, but the argument has proved too flimsy, given the absence of tangible negative externalities.

Rising Inequality

For all of it’s size, voracious growth, and absolute authoritarian government, China remains a very un-united place. To contrast widespread belief that a growing middle class in China will sustain absent foreign demand for Chinese goods in an immediate future void of Western consumer strength, the following points warrant attention:

1. There are no nationally universal social programs where the rubber meets the road. The central government leaves the design, planning, and implementation of most social services such as education, health care, and infrastructure up to the lower tiers of government.

2. The wealthiest Chinese province has 13 times the per capita GDP and 8 times the per capita spending magnitude of the poorest province. Likewise, the richest county has approximately 40 times the per capita spending of the poorest county. (World Bank 2008)

3. At the rural level, where 607 million citizens (46% of the population) live, it is common for education and health care to be the burden of the family if it is available at all. In 2004, urban areas housed 80% of health care facilities, where only 40% of the population lived. (World Bank 2008)

4. As of 2004, spending expenditures for education were borne 78% by townships and 2% by the central government, while the schools were nearly unregulated by the central government. (World Bank 2008)

5. From 1993 to 2003, the top tiers of government in China have greatly increased revenues through new tax programs, yet lower tiers of government are receiving a 5% lesser share of expenditures. (World Bank 2008)

These conditions are synonymous with a developing nation, and are to be expected in China, but regional wealth disparities and the organizational structure of public finance in the PRC have set the stage for problems in years ahead.

Similar to organizational structure in much of Asia, age is considered directly congruent with wisdom and rank trumps all. Evidenced by the World Bank report “Public Finance in China”, decrees from top Chinese leaders and World Bank representatives for higher outlays in education, health care, and infrastructure projects have been announced. Unfortunately, as orders funnel down from Beijing to provincial directors, county offices, and villages, more is asked of the lower tier while less funds are given. The townships are left with beleaguered budgets, lead by individuals focused on promotions rather than sustainability. As a result, the prospects of each town in china are directly dependent on industry or natural resources at their disposal, which they can then use to leverage financing for basic social services.

Path of Least Resistance

The methods, by which towns fill the gaps between revenues and expenditures, are referred to as “off budget sheet” endeavors. These sort of activities are highlighted by Northwestern University Professor Victor Shih’s book, Factions and Finance in China, as he relays firsthand accounts of openly abused relations between private enterprises and public financial policies in the PRC. Simply put, the “private sector” is forcedly co-dependent on the absolute authority of the central government, while the central government regularly turns a blind eye to unjust activities.

One method of off balance sheet financing is where local governments trade loan guarantees for kick backs or invest in private projects with government funds to meet their required levels of economic growth or social expenditures.

Chips Falling

On March 8, 2010, China announced they would “nullify all guarantees [that] local governments have provided loans taken for their finance vehicles”. These “vehicles”, Professor Shih claims, amount to approximately 11.4 trillion Yuan (1.7 trillion USD) in 2009. According to Chinese official Zhou Xiaochuan, land guarantees made by local governments as a form of capital down payment for off balance sheet private loan agreements “may pose risks for the nations banks”. In a country where average real estate prices rose in 70 major cities by 10.7% year over year in February 2010, it would appear that appraisals of land collateral may propose serious risks to the financial system.

Regardless of obvious parallels to the housing bubble in the United States from 2004 to 2007, the real concern with a Chinese led global recovery, is the uncertainty tied to a centrally planned economy that remains exceedingly opaque. Behind the “red veil” economic data is inconsistent, interest rates are manually set, and currency exchanges are pegged or de-pegged, given the best interest of the state. Many have far too tamely to relied on the Chinese led recovery, yet simple assessments of the U.K. and Japan yield debt ridden economies with retreating consumers.

Memories are short and profits idle fear. It seems impossible that China could fail because they have yet to do so in this crisis. Does this make it any less probable? Does it make it more probable?

The half Joseph Stalin half Adam Smith economy continues to roar at 10.7% GDP expansion, in the final quarter of 2009, yet the majority of consumer markets have been slow to follow suit. Chinese stimulus can be thanked for the birth of domestic consumerism in China, as households have been given vouchers to buy specific goods, creating demand in centrally targeted industries. Simultaneously, all levels of government opened the faucet of liquidity, through low borrowing costs and lax loan requirements, which has accelerated the churning out of western style real estate for consumers to fill with all their new stuff. The price tag on China’s stimulus so far scans just shy of $600 billion USD, representing 13% of GDP in 2008 and well above spending in the U.S. and Korea, closer to 5% of GDP for each.

As an Expat living in Korea, I can vouch for the tangible business and expansion that has been rumored to have begun in the East. The steady export market in China has buffered job losses and allowed entrepreneurs to take advantage of the record low interest rates which have spanned the globe. The result, through the eye of an American businessman, is a crane filled skyline in motion and downtown retail epicenters furious with life. It all seems eerily familiar to the consumerism evident in the U.S. circa 2004-2006, and is founded on an assumption perhaps less ridiculous than the “forever appreciating U.S. home price” fallacy, but equally as probable. The new assumption serving as the global economic engine, is that China’s 10% growth is not only sustainable, but that it will occur for the foreseeable future.

Let’s look at some of this “sustainable” growth more closely:

- 2008 China GDP = $4,327 Billion (World Bank)

- 2009 Unrevised China GDP = $4,910 Billion (China Daily)

- 2009 Q4 China GDP Growth = 10.7% (Xinhuanet)

- 2009 Outstanding Loan Growth = +$1,400 Billion = 28.5% GDP (2009 Est.) (WSJ)

- 2009 Broad Money Supply Growth = 27.7% (WSJ)

- 2009 GDP growth = 13.5% (unadjusted for inflation)

Recently markets have operated under an irrational paradigm where prices don’t move until the reality of the situation is forced down our proverbial throat. Ironically it seems that the rumors, fears, and speculation about asset bubbles in China are enough for the communist leadership to forcefully hit the breaks on loose liquidity expansion. The ICBC will curb lending in 2010 by 25%, no doubt to moderate the pace of inflation and domestic growth, as it out-paces the anemic recoveries elsewhere across the globe.

This idea that China saw peak economic acceleration in the last quarter of 2009 hasn’t sat well with market movers. While stricter borrowing standards may benefit all, helping to avoid a collapse akin to the U.S. real estate failure, the return to reality has traders scratching their heads for reasons to buy. Added stress from a reversal in the U.S. housing recovery and a weak demand forecast from multinational Caterpillar (CAT) have contributed to the past week’s decline.

It’s fair to say that the global recovery is fundamentally based on strong growth from China, while there is evidence that GDP growth in the cheap U.S. dollar-tied-Renminbi may be eroding sales from global competitors and misrepresenting global consumer demand. This week’s negative outlook on Japan by Standard & Poors and manufacturing woes in Germany, beg that such fears are rooted in truth. Combining these symptoms with an autocratic body of leadership, resistant to allowing its currency to freely appreciate, has exposed the China led recovery to criticism.

It isn’t hard to distinguish Asia’s beating heart, albeit is any man’s guess whether the continent’s overall return to growth lives or dies. China is a formidable 1.3 billion strong populace, the world’s third largest economy, and yet the IMF ranks the nation’s per capita GDP 89th. As blind as justice, markets may now be signalling that the still developing nation cannot lead the globe from the stimulus injected foundations of recovery to global economic expansion. Whether they are right is up to each of us to decide.

Three and six month treasury bonds will be auctioned at 11:30 am Monday and will kick off the monthly test of the demand for short term investment security. The dollar is becoming stronger and rumors, spawned from the announcement of Bond King Bill Gross's "Lehman high" cash levels, are beginning to spur renewed debate over the steepness of the yield curve. The yield on the 10-year has been following the dollar higher, and traders can look to capitalize on further dollar gains by shorting the debt with an ETF or ETN like (TYO).

Tuesday

Redbook (8:55 am) and Goldman's ICSC (7:45 am) store sales comps will be scoured for details as the market looks to zero in estimates of the amount of spending going into holiday shopping when compared to the previous year and may show signs of hope to rally stocks through the Thursday close if numbers surprise to the upside. The GDP number will get revised slightly, expected to drop 0.1% to 2.7% for the 2009 Q3, but will not have any effect on prices unless a larger revision pops out. We'll get existing Home Sales at 10:00 am and FHFA House Price index at the same time, both of which are expected to show further strength in housing. Any disappointment in housing will be a hard pill to swallow as bulls are basing more of their equity rally extension theory on the industry.

Wednesday

Housing news from the MBA Mortgage numbers will cross tickers at 7:00 am and will set a negative tone for the remaining data, should the results further the anemic results of the past week. Personal Consumption Expenditures (PCE) data, out of the Income and Outlays report at 8:30 am, is expected to show a 0.6% jump in consumption along side price increases of only 0.1%. At 9:55 am the second and final leg of forward looking Consumer Sentiment will prove or disprove the solid improvement to 73.4 earlier in the December. Traders will take this report and run with it into the Christmas weekend and positions should be closely watched if sentiment surges or dives from the 73 mark. The July peak at 430k annual U.S. homes sold has been hard to breach after a sharp drop in September, but Bloomberg economists think the November report will be the one to show builder's confidence ahead of the 2010 Spring buying season. The consensus for the new homes report is 10k higher than October at 440k, and is expected to show confidence in the disgraced industry moving towards the new year. CME traders keeping a sharp eye on the EIA Report at 10:30 will be trigger happy with January delivery futures contracts nearing expiration and crude supply leveling off at the absurdly high 330 million barrel mark. 

Thursday

Durable Goods orders out of the gate early at 8:30 am are expected to make up for a -0.6% drop in November by increasing the amount of machinery on order by 0.5%. Last month the metric disregarding automotive orders fell a larger -1.3% as manufacturing seems to have seen most of the benefit from inventory rebuilding and big ticket purchases are pared back. Jobless claims jumped 7,000 to 480k last week, but are expected to fall 10,000 as layoffs subside. However, many employers save job slashing until after the holidays, begging that January's numbers will tell the full employment story. Money Supply and the Fed Balance sheet will be closely watched for changes this week as the story of the strengthening U.S. Dollar is criticized and supported by traders on both sides.

Disclosure: Long DTO, Long TYO, Long SDS, Long SCC

Monday

While equity and commodity prices will likely pop on monday in U.S. trading, the release of real economic data will be slight. At 9:45 EST the Chicago PMI report will release its headline number, which Bloomberg analysts expect will drop to 53.0 from the 54.2 October level, the highest since September 2008.

Tuesday

Motor Vehicle sales will cross the ticker sometime during the day and will be hotly anticipated by auto analysts, looking for a trend in post-"cash for clunkers" sales. With October sales rebounded at a 7.9 million unit pace and expectations for a 7.75 million annual sales statistic in November, the street is expecting a cooling of the market leading into the holiday shopping months. ISM Manufacturing results hit 55.7 in October for the highest rate since mid 2006, but are expected to slow to 55.0 for the month on signs of less strong new orders when the report is released at 10:00 AM. Construction Spending and Pending Home Sales will also be released at ten o'clock, shedding some light on the hotly debated bottom in housing, claimed by some to have already formed. Expenditures made for construction is expected to fall from September's 0.8% monthly increase to a declining -0.4% rate. Pending Home Sales may see a decline from the drastic jumps over the past two months, where the back to back 6%+ monthly increases led to the year over year rate ballooning to 20%. Unfortunately pending contracts have been dying short of actual deals, due to obscure appraisals amidst the still uncertain price discovery process.

Wednesday

Wednesday will see the ever vague "Beige Book" released by the Federal Reserve but the report will likely be a whitewashing of rhetoric and supportive statements concerning the health of the U.S. economy, where any pessimism would certainly be against the Fed's Dual Mandate.

Thursday

The Productivity and Cost of Production report is expected to show 8.6% productivity growth in 2009 Q3, compared to 9.5% in Q2.The report, released at 8:30 AM, is also expected to cite average costs of businesses down by a -4.2% rate, less than the -5.2% in Q2. At 10:00 AM we'll hear from the Institute of Supply Management for the third time of the week, as the ISM Non-Manufacturing Report headline number comes through. Traders will be looking for a solid gain from nearly stagnant growth in October (50.2) to 52.0 on the November service sector report card. This gauge of business un-helped by inventory rebuilding, has struggled to show meaningful gains above the break even 50.0 mark.

Friday

While every day this week will birth crucial economic data, the irreplaceable November Employment Situation report will have the world glued to electronic displays at 8:30 AM EST on Friday. Jobless rates are claimed to be lagging indicators, but the constant buzz over the staying power of the current stimulus recovery has begged investors to keep a tab on the rising rate of unemployment. October saw 190,000 additional non-farm payrolls slashed, while the household survey showed a larger jump to 10.2% unemployed. This month the consensus is for 100,000 payrolls to be lost as the headline number remains at 10.2% without jobs. Later at 10:00 AM we will also see how Factory Orders have changed over November, where new orders are expected to decline to nearly even at 0.2%, yet markets will move mainly on sentiment derived from the Employment Situation.

Bernanke's Mandate

The Fed Chairman went one step further to assure the audience at the Economic Club of New York that his board of governors would "continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability." 

The Fed's Choices

While the Economic Club might have bought it, the mandate is nothing short of contradictory and insults the intelligence of the market. Regardless of the billions of dollars the Fed extends or withdraws from the GSE's, the passionate Bernanke yarns of dollar strength, and Obama-talk about the importance of jobs, the Fed has these simple two options… keep the Fed Funds at 0% or raise it.

0% Fed Funds Rate

If the Fed keeps the rate at 0% the U.S. economy may see a peak in the headline unemployment number sometime in mid 2010, thus addressing the jobs end of Bernanke's mandate, but not without triggering asset appreciation all across the world. This was a successful exit strategy to the prior recession in the U.S., allowing businesses to invest at cheap rates and create jobs for consumers to invest back in the appreciating assets (homes). However 0% rates are currently only allowing institutional investors and governments to borrow funds, who have then invested them in risky assets such as U.S. Equities, Commodities and Emerging Markets. This carry trade continues to devalue the U.S. dollar and decreases the purchasing power of strapped U.S. consumers.

This time businesses can't secure financing from banks because their balance sheets remain in shambles, prospects for earnings growth are dwindling, and consumers continue to lose their jobs. Data out this week showed Q3 2009 posted a record 6.25% of total U.S. mortgage holders in delinquency, proving that 0% Fed Funds rates offer no comfort to those who need it. 

Quantitative Tightening (QT)

QT is an option and should be realistically considered as the only alternative to severe long term inflation. Critics of this view will cite the PPI (Producers Price Index) core statistic's decline of -0.6% in October as evidence to support a deflationary or neutral environment, yet the true effects of artificially inflated commodity prices won't be felt by consumers for some time. Contrarily, the report showed crude goods prices increased by 5.4% over the same period. Should interest rates remain low long enough to increase already inflated asset prices and consumers remain jobless, the result will be a pinched supply chain. Input prices will continue to rise as output prices stagnate or fall and companies/workers go out of business.

The only responsible option for the Fed is to begin QT now and take whatever pain comes along with it. Australia has already begun raising its Fed Funds target and will soon be followed by others, yet Bernanke reaffirms and extends his window of 0% rates until mid next year or later. Meanwhile the charade of talking up the Dollar and failing efforts to lure China into de-pegging the Renminbi amidst a Sino-recovery founded on the cheap currency.

Talk is cheap Mr. Bernanke and so is the Dollar. Keep the USD from falling further by raising rates and weathering the potential short term pain. Many may hate you in the short run and equity markets may turn south, but we will avoid a decade of stagnation, emerging stronger and faster because of it.

Price To Earnings

Twenty four months spanned between the peak 6.5% Federal Funds Rate mid summer 2000 and the screeching halt to 1% in December 2003, where rates would would hover through Independence Day of the following year. Prior to new millennium S&P 500 P/Es in the forties and the ensuing share price slashing, one must scroll back to 1961 to sight a Fed Funds Target below 2% and further to 1954 to find the over night rate below 1%. Similarly, we forget that prior to 1995 the S&P 500 last carried a P/E ratio greater than 25 in 1930, yet this fundamental statistic remained above 20 for the duration of the previous recession and until October of 2008.

The American Dream Home

Prior to the 2001 downturn there had been sweeping legislation to extend the "American Dream" of owning one's own home to those in lower incomes. Mortgages were generally originated by third party shops and purchased by the GSE Fannie Mae and Freddie Mac mortgage strongholds. Beginning in 1996, the United States Department of Housing and Urban Development (HUD) policy mandated that a minimum percentage of the loan portfolios at Fannie and Freddie be sub-median income products, totaling 52% of all GSE guaranteed mortgages by 2003. The appearance of Alt-A, interest-only, and ARM mortgage products became the bread and butter of "lip-smacking" originators, then passed on and digested into fortune 500 banks' balance sheets, as a Moody's/S&P rated package (i.e. CDS & MBS instruments). 

Housing Recovery 1.0

The first time around, households stopped short of buying new homes until 30-yr fixed rates ratcheted below 6% in January 2003 and remained there, tethered to near 1% Fed Funds rates, until October of 2005. Prior to 2003 30-yr fixed rates were last seen near 5.71% before 1971, where the Freddie Mac data stops, while the New York Times vouched that such low rates hadn't been seen since the early 1960's. Ensuing asset price inflation derived from cheap money and an unquenchable demand for homes brought the economy out of recession with a booming pace, as the resultant vector of growth came founded on consumer spending.

Fannie and Freddie

The mortgages purchased by the GSE Fannie Mae and Freddie Mac strongholds, facilitated "zero down" financing to less wealthy individuals wishing to own a home and strong propaganda to hopeful politicians. Barney Frank went on record supporting the HUD policies for riskier mortgages carried by the GSEs and continued to support Fannie and Freddie even as the CEOs endorsed the addition of "Alt-A" products as a major part of their business. Last week the total tally of Government capital infusions at Freddie capped the $60 billion mark, as Paul Miller of FBR Capital claimed "they are going to need [all] $200 billion in capital" promised to the firm by the Treasury.

What The Data Says

GDP data tells us that residential investment increased by an average of 7.35% per year for four full years until leveling off in the fourth quarter of 2005. The mass of capital which flooded the residential real estate market 2002 to 2006 was so great that the four year average residential investment figure jumped 22% from the prior four years, a move of an additional $126 billion/year, while since 2006  residential investment by consumers is down an average of 20% per year.

The yarn of the previous crumbling housing market isn't alone prophetical, but through inspecting recent history we can infer what contribution a recovering housing market could have on GDP, deriving it's effect on the U.S. economy as a whole. 

Fed Quantitative Easing (QE)

Concluding that the only answer to such an indebted private market was to shift the burden of current debt from private to public balance sheets, the U.S. assumed effectively all risk which had caused the large banks to be shorted in the first place. When the overnight target rate for banks to borrow among themselves crashed at 0% and LIBOR (London Inter Bank Overnight Rate) remained high, the Fed resorted to physically buying and insuring the toxic debt which is still defaulting to this day, simply on the public rather than private watch. When the Fed had thrown the proverbial kitchen sink of QE at the problem and the green Obama administration announced banks' shares would remain private, the financial stocks recovered and the broader indexes followed.

Main Street Stimulus

Shell shocked lenders left a shrapnel economy in their wake, claiming 700,000 initial jobless claims at peak and awful consumer confidence numbers. Along came the Obama $700 billion stimulus, said to be designed with shovel ready projects and job creation strategies in mind, but once congress dissected and reconstructed the bill it had that same old pork barrel stink. Obama's C.A.R.S. (Car Allowance Rebate System) program was an effective durable goods stimulus on par with those of China and Brazil, known as "cash for clunkers", which drove new car sales statistics above 10 million units per year for the first time since a year prior in August 2008. 

Housing Stimulus

The "First Time Home Buyer" tax credit, initially announced in 2008 to buoy the falling demand for new homes, was designed as a no interest loan to be paid back over 15 years. When the plan failed to stick, the administration altered the plan to where buyers never had to repay the tax credit and it was increased to a maximum of $8000. As the tax credit was set to expire in December of 2009, congress rushed through a six month extension of the credit, through June 2010. Additionally, the tax credit applies to a much higher tax bracket and to any person wishing to buy a primary residence. Keynes would argue that the expectations of consumers for the tax credit to end would have flushed all first time buyers out of the system thus far but that perhaps second or third time buyers would flock to the offer. The program seems to be working in the short term as the following chart depicts in the bottoming of home prices in the largest 10 and 20 city composite indexes, composed by comparing repeat sales of homes.

The Bottom In Housing

It's plainly obvious that homes prices have stabilized in dollar terms from the chart above, combining with the seasonally adjusted existing home sales increase of 9.2% in September 2009 from a year earlier, thus making a "bottom in housing" a technical victory. Doubly encouraging are the "months of supply" of homes on the market has decreased to 7.8 months from the peak of 11 months in November of 2008. The above data is uplifting and potentially foreshadows a prosperity founded on yet another housing recovery, yet it's equally likely that the devalued U.S. dollar accounts for much of the shift in prices and that stimulus takes recognition for sales. Indeed we would argue that there remains the possibility for home prices to dip lower should the U.S. Dollar gain strength or stimulus effects on sales run their course and resume the previous demand vacum, potentially creating an inflation discounted "real price" which continues to fall.

(Note: Remaining GDP Component growth normally a driving force in the growth and recession of the economy (dark blue), yet in Q3 of 2009 these remaining components accounted for marginally positive growth. Instead stimulus induced Durable Goods (CARS), Residential (1st Home Credit), and Government Spending components carried the growth with an additional boost from inventory restocking.)

China's Role In U.S. Recovery

A recent article in the Economist explains how a similar recovery of asset appreciation tied to exports may result in frothy demand, should domestic consumers begin consuming Chinese services in addition to goods. It would be possible for China to accomplish such a task only if the G20 succeeds in convincing the nation to float its Renminbi currency and increase the purchasing power of it's consumer base, contrary to the export heavy interests of the BRIC leader's central government. How then would an asset appreciation recovery in China effect America's economy, when assets here are only appreciating in dollar terms but remaining flat in foreign currencies (the case in recent months)? We would argue that it would effect America quite badly, and only cause an asset appreciation bubble in China and nations with high enough savings and stimulus to kick start private spending or economies tied closely to commodity production.

Whatever the role housing played in the previous recovery, it's unlikely that early signs of a bottom in the industry will spur favorable growth in the medium term (1-3 years), and that instead this recovery will need to be based in an industry coiled more tightly to spring into production, of which there are no real studs. Perhaps most important is the ability for the global market to truly account for the over-exuberant lifestyles of consumption and greed which led to such hardships, manifested through all forms of global commerce. It was not one flawed industry, cracks in regulation or the failure of markets but instead the failure of self regulation and self inspection at every level, which brought us to the seemingly unanswerable decision between more spending or more pain. 

Standing on the pivot, one might see alternate paths to prosperity or destruction given random series of events and outcomes… What will chance hold for the future of global commerce and markets this time? While a sensibly true recovery may be real for some, the exodus of toxic material from financial balance sheets at every level must come to pass for a harmonious global economic balance of growth to sustain over time.

In the chart it's plainly evident that the 10 Year U.S. Treasury Note yield increased into the early 1980s near the point where mortgage rates peaked at 18.45% for a 30 year fixed rate product, in October 1982, and the "S&L (Savings & Loan Bank) Crisis" began. Since the 1981 high yield of 15.84%, the 10 Year U.S. Note has neared the point of zero amidst accelerating deficit spending over the past decade.

The U.S. yield curve, based in a soppy overnight rate at 0%, has been tamed by Ben Bernanke's $300 billion program to buy 10+ year Treasury obligations and the less public Federal Reserve purchases of "toxic assets" from the GSE's and Government owned banks (Citi and Bank of America). Recent decisions to remove these two methods of backstopping American finance will effectively release the long end of the yield curve out into the wild. Interestingly, the Fed concluded to remove these measures amidst a climate of stagnation in economic activity and talks of further stimulus on Capital Hill, both headwinds to the perceived solvency of the U.S. government.

The strategy of shorting U.S. Treasury Debt is the only strategy that makes you money over the medium term irregardless of nearly every possible economic outcome. Should the economy recover and the Federal Reserve begin quantitative tightening by raising short term rates, long term rates will also rise as demand will fall for government debt replaced by riskier assets. If the economy turns back into contraction and stocks fall, demand for treasuries may spike temporarily but the bid to cover ratios in current auctions already signal un-sustainably high demand and will only drive yields lower for a very short time. As the economy weakens and stocks continue to fall , investors will pull out of U.S. government bonds due to fears of revenue destruction and insolvency. In the contraction scenario, there will be no desire to lend to the debt heavy U.S. government as Uncle Sam's AAA credit rating is again called into question.

The final risk to this strategy identifies the recently narrowed U.S. trade deficit, which had contributed to the steadily increasing demand for long term U.S. debt since 1982. Surplus dollars received under more unequal trade levels by foreign counterparts were invested almost completely in American bonds, thus driving the yields continuously lower and further perpetuating the American consumption that was fueling the deficit growth in the first place. This however is the final bubble which has yet to burst that will finally cleanse the over-leveraged consumption by the developed world, having followed the lead of the United States. In the unlikely event that U.S. consumption returns and trade deficits resume, trade partners have already shown their desire to hold tangible assets, signaled yesterday by India's trade of 6.7 billion USD for 200 tonnes of Gold (7% of the world's annual gold mine production). It is therefore our view that any "risk" of a resumption to the previous norm of global trade inequalities is counterintuitive and that growing imbalances with India and China will discourage policies to bloat their surplussed coffers with the final toxic asset… U.S. Government Debt.

To implement this strategy it is easiest to simply buy the Direxion Daily 10-Yr Treasury Bear 3X Shares ETF (TYO). This ETF gives you enough leverage (3X) to profit from the relatively minor swings in Treasury Yields and is much safer than actually shorting the U.S. 10 Year Note, because your losses are limited to the initial investment made. Make note, this fund will fluctuate directly proportional to the yield on the 10-Yr Treasury Note and inversely to the price.

The real fear for banks is that the probable need for further equity offerings will come to pass in the near future. British and American bankers both face a real danger as equity prices become less and less attractive given the simultaneous declines of the currency in which shares are held. Over the past 200 days the S&P 500, the per ounce price for gold, and the WTI continuous spot price for crude oil have increased by 25%, 30%, and 80% respectively, while the US Dollar index fell by 10%. The three assets increased by varying degrees of intensity, responding congruently to market moving news throughout the period following the March 9th lows, while the dollar's value changed with a negative correlation. 

According to the chart, it were the commodities who outperformed the US equity market since the March 9, 2009 low of 666 for the S&P 500. Then, why should foreign investors risk allocating funds to U.S. corporations bearing 20+ P/E valuations and an increasingly jobless consumer base. It is increasingly likely that they will avoid such risky assets as U.S. stocks, where the average price appreciation over the past 200 days is halved when accounting for the drop in the value of the dollar. 

On top of these inflationary pressures, equities in the U.S. and Britain will most likely begin to depreciate as firms, not limited to the aforementioned banks, including U.S. Tarp recipients such as Bank of America and Citi Group find ways to raise additional capital needed by breaking off business arms and issuing more shares. It is the increasing share issuance, occurring as companies squirm for much needed capital, which will dilute shares in the coming months.

Finally, the dollar will likely continue it's inverse stickiness to equities as commodities maintain a direct correlation for a period of time following the imminent pullback in equity prices around the globe. The absence of stimulus and optimistic guidance for the next few quarters amidst rude reports of struggling economic activity will pull down all asset classes along with commodities. But should equities fall through one or more levels of resistance and begin to change the tone from one of hope to one of fear, commodities will break free from the current trend and spike upwards as the dollar begins to fall on the fears that inflation will mix with a retreating consumer.

The U.S. Fed, Treasury, and White House have made it brutally apparent that they will not take "no recovery" for an answer and will continue pumping money into the system by whatever means necessary. Yet there will come a time when the global appetite for U.S. debt will curb and the pressures of inflation will truly be felt. This time will be signaled by the market and will become apparent when equity markets fall on news of further stimulus spending. It appears that yields on long term treasury debt are already beginning to rise as the $300 billion Fed purchase program of such Long-Term U.S. paper has ceased, and may cause real interest rates on long term U.S. debt to increase. Unfortunately, such a decrease in demand for U.S. Debt would exacerbate the ill effects that a widening U.S. current account deficit will have on the dollar. A growing current account deficit had been largely responsible for the falling U.S. Dollar index from 2002 through 2006 that, despite it's narrow levels not seen since 1991 at 2.8% of GDP, will ultimately trend wider.

The weak dollar has most recently been fueled by the widespread dollar borrowing to fund "carry trade" investments, where the expectations for a near zero Fed Funds rate to remain low hurt the value of the dollar. When the Federal Reserve signals that it will begin tightening it's quantitative measures, another currency will take the place of the dollar, causing it to appreciate in the short term. However, fundamental headwinds facing the U.S. currency described above will ultimately outweigh waining carry trade borrowing to drive the value lower.