div align=”justify”Back on December 7th I noted that em’the probability of a very dramatic rally in equity markets of 20% in coming weeks is high and rising, taking the Dow over 10,000 again’/em and I stand by that view, implying up to 1100 on the Samp;P. emstrongThe mountain of cash on the investment sidelines (about $8.8trn) earning a minimal return in Treasuries and money market funds as the Fed cudgels conservative, prudent savers and marches them up the risk curve/strong/em, will get redeployed over coming weeks as confidence in the rally and recovery momentum grows. I also suggested that long term energy exposure was attractive, as the oil price had undershot to the downside unsustainably, and that view is now being vindicated by strong sector performance. However, make no mistake, emstrongthis bear rally which will run maybe 33-40% from the November lows will be a wonderful opportunity to raise cash or hedge exposure before a new panic arises by late Spring or early Summer/strong/em, re-testing and quite possibly crashing through the recent 740 Samp;P low. We’re entering Act 3 of this horror movie, and after a respite for dramatic effect, that’s when things get really gory. /divdiv align=”justify”Not only will we see a huge spike in US corporate and municipal defaults through mid-year, rising geopolitical risks resulting from the politically destabilising fallout from the economic slump, and a likely further fall in Samp;P 2009 earnings forecasts to $50 or below but we’re in a bizarre and dangerous scenario where monetary policy has become divorced from money. emstrongThe Fed, rather than passively supporting the necessary cyclical de-leveraging process, is actively targeting asset prices/strong/em, hence the massive increase in its balance sheet in recent months as it seeks to make non-liquid assets attractive to banks to get them to lend again. emstrongMonetary policy is essentially focused on inflating America’s way out of a smothering debt pile by any and all means/strong/em emstrongpossible;/strong/em so far, US money supply has exploded, but the velocity of money ie its multiplier effect through the real economy via credit creation, has remained frozen./divdiv align=”justify”The US monetary base (basically its currency in the hands of the public and the reserves in the banking system) has soared to $1.7 trillion, much of this due to commercial banks depositing reserves at the Fed, which seems like a copy of the Japanese strategy of boosting a ZIRP regime by kick-starting interbank lending, with each bank comforted by the certainty of their counterparty’s massive excess reserves. /divdiv align=”justify”However, emstrongthat Japanese plan only ultimately worked when banks finally disclosed the full extent of the toxic debt on their balance sheets/strong/em, and that transparency is still lacking in the US and elsewhere. There are many dangers in this frantic monetary fire-fighting which I will discuss in future posts, emstrongnotably losing the confidence of key foreign buyers in the Treasury market and dollar, despite current efforts to ‘game’ long-term yields down. There is a real risk of igniting serious inflation beyond 2010/11/strong/em if the monetary transmission mechanisms begin to normalize. Hedging against long-term inflation via hard asset exposure and TIPS is wise on this view. After the TARP debacle, US economic credibility this year is on the line as never before and any missteps will be cruelly punished by global investors. Enjoy the ride./divdiv class=”feedflare”
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Last 5 posts by Sean Maher

• Who was Smuggling $134bn in US Bonds into Switzerland? - June 12th, 2009
• Geithner Toxic Asset Plan Collapses: Will US Banks Follow? - June 10th, 2009
• US Unemployment hits 9.4%...that's Bullish, Right? - June 5th, 2009
• Oil Price Surge: Deja Vu? - June 3rd, 2009
• China Hedges Against US Inflation... - May 28th, 2009