Forex rebates on every trade - win or lose!

Gausie, i am looking at forex and will start from monday,i will be interested in the chatroom,could you please send me info to scussy@ntlworld.com

cheers
steve

Afternoon everyone. Easing myself back into Cable after a health scare which I hope has been resolved satisfactorily. Thanks Hilary for asking about me and to those who sent their regards via Bakko. I appreciate it.

Monday should see me back trading or at least feeling my way around again. Til then, happy trading and a Happy and Prosperous New Year.

LOL well I might have got that slightly wrong earlier...

Daily support looms now at 1.9250

anyone ride this thing down here...

:-)

Currently playing with FXCM's system, trial long from 1.9394, was long from 362 but trying to set a stop I managed to close it - only play money at the moment. The trailing stop in FXCM is really useful. edit stop is now at entry.

Does my stop look to tight in this?

SC: I'm also playing with FXCM.

A beauty contest for misshapen half-wits

Even Wall Street agrees the Pound Sterling must tumble. So why have central bankers been buying all they can get...?


Everyone wants a piece of the UK today. Bill Bryson just got himself an honorary gong. Monty Python's 'Spamalot' musical will soon hit Las Vegas (it's a hoot, by the way). And half-a-million Polish citizens are now living in Britain to earn Sterling, not Zloty.

Should US investors hail a black cab to Britain? Hold the Pound up to the light before you hedge your Dollars this Christmas.

Check the watermark. Make sure the metallic strip is intact. Then read the "promise to pay" signed by Mervyn King, Governor of the Bank of England. It's just as empty as the promise on US Treasury notes. Nothing but more fiat promises back it up which will work fine so long as everyone accepts Sterling in payment of debt.

But the Pound is set to fall hard, according to two big US investment banks. Goldman Sachs says the Pound is 13% over-valued on a trade-weighted basis. Lehman Brothers are gloomier still. "I'm not saying that things will be terrible, but they will feel much worse," warns their chief UK economist, Alan Castle. He sees Sterling falling to $1.82 next year, before sinking to $1.68 by Christmas 2008.

Wall Street's reasons are simple. They might give you da vu, too. For Great Britain and the United States have much more in common than merely the mess in Iraq.

Just like America, Britain is currently running a huge trade deficit with the rest of the world. The largest shortfall in Western Europe, it reached a near 18-year record this fall. And just like America, Britain also has a mountain of government debt.

Officially, public sector net debt stands at 486.7bn. That's equal to US$953.9bn and represents a little under 38% of annual GDP. Add the state's "off balancesheet" debt, however including its pension promises to state-paid employees and the total shoots nearly three times higher. Research by the Centre for Policy Studies in London says it would put UK government deficits at a staggering 103% of GDP. The debt burden per household would be over $103,880.

Then there's consumer debt only here, Britain is way ahead of the States. Total consumer liabilities now run to an entire year's worth of GDP, thanks to house prices tripling since 1996. That's when the last wipeout troughed. It started in late '89 and knocked average home prices, adjusted for inflation, down by 35% and beyond. Fast forward to Dec.'06, and the British now owe $2 trillion in housing debt, much of it held as a naked call otherwise known as interest-only home loans with no money down.

Now add unsecured debt per household of $16,840 on average...plus personal bankruptcies doubling to an all-time record since 2004...and "the surprise is that the Pound has been so strong," gasp Lehman Brothers. "Current account deficits matter over time," the suits in the City remind us, "and we're worried that Britain's [trade] deficit could widen to 4% of GDP in 2008."

But c'mon! What took Lehmans so long? None of this trouble is new. And other US investment banks have called the Pound lower before. Trouble is, they were wrong.

"As a top trade for 2005, we recommend going short AUD, GBP and NZD," said Morgan Stanley in January last year. By their expert math, these three Anglo-Saxon currencies were all "overvalued [and] no longer trading on fundamentals." That bit was right, but the trading idea was not. If you had sold the Aussie, Kiwi and Sterling against Euros and Dollars in 2005 it would have cost you dear long before now. As 2006 draws to a close, the trade's barely back in the money.

And all this while, the Pound has grown weaker on all fundamentals. Britain's broad money supply has exploded 25% since the start of '05. That's the fastest growth by far amongst the G7 economies, and nearly twice the rate of world money growth judging by the Bank of England's own data. Worse still, in early April this year, Dollar interest rates overtook Pound rates for the first time since 2001. This didn't bode well for Sterling, as a research note from HSBC said.

During the previous three decades, the GBP/USD pairing known as "cable" by traders had lost 12% per year on average whenever Dollar rates were higher. Yet this time the Pound shot higher against the Greenback as the yield-premium went Stateside. In fact, it leapt 15 cents higher to $1.90 within only five weeks!

So who's been filling their boots? It's a good job that Sterling broad money has risen so fast. Because the Pound has become the "anti-Dollar" of choice for the world's central bankers.

"There are not many places to go once you decide to get out of the Dollar," shrugged an official from the Banca d'Italia in August. Italy's monetary wonks had just said that Sterling accounted for 24% of their foreign currency reserves. They didn't hold any in 2004.

"Japan is always a question mark," he shrugged again. "At least the British economy is humming along okay and UK bonds offer a decent yield..."

In other words, Sterling is better than a poke in the eye. And it's thanks to that logic, says a report from the Bank for International Settlement (BIS), that the Pound now accounts for 12% of all foreign reserves held by governments worldwide. In fact, the UK currency underpinned by record inflation of the money supply...record house-price inflation...and near-record trade deficits is now the world's third reserve currency, second only to the Dollar and Euro.

What's to love about Sterling in this beauty contest of misshapen half-wits? Put simply, it isn't the Dollar or Euro. Nor are buttons or whale's teeth, of course. But a government vault full of cowrie shells would be tough to explain next time the wonks met for dinner in Paris. And the same sorry logic is at work on Wall Street, remember.

Lehman Brothers say Sterling will drop to $1.68. Goldman Sachs forecast a 13% drop or more versus the Dollar. Morgan Stanley this summer set "fair value" at $1.63. But what if the Dollar keeps falling...and Sterling falls too? Where will central banks turn next as they try to spread their currency risk from one fiat money to another?

"In the 1980s," the BIS says, "the Yen had begun to erode the US Dollars share [of central bank currency reserves]. At its peak the Yen accounted for over 10% of reserves. By 2006, it accounted for less than 5%. The decline in Japanese asset prices and the subsequent long period of low relative returns on yen assets appear to have contributed to the shift out of Yen reserves...The pound sterling has replaced the yen as the third largest currency in reserve portfolios. According to the BIS data, the share of sterling doubled between 1995 and 2006."

Funny, but the UK economy looks uncannily like late '80s Japan Inc today...only in miniature and minus the trade surplus. Yet central bankers have piled in regardless. Even the Swiss have bought Sterling, pushing it to 10% of their foreign exchange reserves! The BIS can't be sure what China, Japan and Russia have done. The three largest owners of foreign exchange reserves now deal secretly through private bank transfers to avoid telling the market what they're selling or buying. But Russia collects some $12bn per month thanks to its oil and gas sales. Sterling's strength in the currency market says it can't all have been destined for Dollars or Euros.

All central bankers now share this headache. The BIS puts total worldwide currency reserves at $4.8 trillion...a full 11% of world GDP. When the Pound hits the skids which even Wall Street knows it must, soon the stampede out of Sterling will send the next-best-thing soaring. In fact, the glut of central bank Pound buying may in fact have already ended.

In October, the official data report, the largest buyers of British government bonds were private foreign investors rather than central banks. Okay, furtive officials in Beijing, Tokyo or the Kremlin may have placed those orders "off book". But if they have chosen to stop buying Sterling, they'll find the four other major currencies in a race to the bottom.

Japanese inter-bank lending pays less than 0.4% today. Eurozone bankers have got all the Euros they want; the "Esperanto Experiment" now yields two percentage points less than the Dollar. The Swiss Franc pays even less, and the Dollar itself...well, you already know how ugly the Dollar now looks.

What about the commodity currencies, Korean Won, or the newly convertible Russian Rouble? "The BIS data suggest," says the Bank's September Review, "that at the margin [central bank] reserve managers have increased their holdings of Australian and Hong Kong dollars, Danish kroner and other currencies in recent years. The share of currencies other than the major five rose to 4% of deposits in 200506."

But there's a snag. For while cash deposits of non-major currencies are easy enough to snap up, there aren't enough non-major bonds to go round. The Dollar, Euro, Yen, Sterling and Swiss Franc account for 83% of the world's debt issuance in total. Most likely that leaves non-major securities too tight. The big central banks can't seriously increase their holdings without freaking the market, most of all at the long-dated end where supply is tightest.

Finally, of course, there's gold. Since it pays no interest in a world always seeking out yield, it now accounts for just 0.5% of all government reserves by value. But now the 5 major currencies all look as bad as each other, then who knows? Gold might just find favor...most especially in Asia.

"It is unfortunate how much [India] has lost by...holding on to the antiquated belief that gold transactions in the market by the Reserve Bank of India are bad, while frequent transactions in USD, Euro, Yen and Sterling are good," said former RBI Deputy Governor S.S.Tarapore late in November. "Gold is unique, in the sense it is both a commodity and a store of value...

"More importantly," he went on, "gold invariably moves inversely with the US dollar and also rises in value when international inflation gathers momentum. Thus, there are strong reasons for holding a reasonable proportion of Indian foreign reserve exchange reserves in gold."

Adrian Ash, 15 Dec '06

Adrian Ash is head of research at BullionVault.com, the fastest growing gold bullion service online. Formerly head of editorial at Fleet Street Publications Ltd the UK's leading publishers of investment advice for private investors he is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.



Central bankers in gold buying shock?

"The week ended the 22nd December saw one of the signatories of the Central Bank Gold Agreement sell and another BUY gold leaving a net sale of 2.7 tonnes of gold," gasps Julian D. W. Phillips at GoldForecaster.com. "It seems that we are seeing a change in policy by European Central Banks...The information is huge...It is deeply significant that a European Central Bank (not just one of the Arab or Asian banks) should actually buy gold."

Further east, and the Russian central bank raised its gold holdings by 2.2% to more than 394 tons in the third quarter, according to the World Gold Council. China should also increase its gold holdings, according to an article published in the state-run newspaper The People's Daily at the start of December. Gold makes up 1.3% of China's vast foreign currency reserves. That's lower than the 3% benchmark used by other nations, says Gao Jie, a professor at the University of International Business and Economics.

Trouble is, China can't switch much of the $1 trillion it holds into gold without squeezing the market so tightly, the price would explode.

Doesn't mean it won't try though. Who knows what 2007 might bring in the race to flee the US Dollar...?

Got an average of 149 points out of recent fall but no time to post details as they occured.

I would be interested in the chatroom Gausie but would only be available on the odd evening due to work.

Chocolat: Interesting stuff. Does that mean you think I'll win my 'apocalypse' $2/1 wager with Hilary? That is, it won't happen?

hilary - What happened to Chelsea last night? :))

It's only half time, Prodman. Chelsea are a second half side.

:o)

Choccy,

I come out in a cold sweat whenever I read anything written by somebody with the name Ash purporting to know about minerals.

:o)

You shouldn't let this phobia get to you, Hils - all you need is a pinch of salt ;)

Oh boy

I'd get your old tin hat out of the loft, MM.

:o)

Nah Hils - he's still got it under his desk :)

He told me that he kept his commode under his desk, Choccy.

7% by year end, MM? This is a direct result of Tone and Gordon The Moron's feeble attempts to cook the books, imo. Let them now reap what they've sown!!!

:o)

The BoE"s accompanying statement says the margin of spare capacity in the UK
economy appears limited, adding to domestic pricing pressures. The statement
says that it is likely that CPI inflation will rise further above its 2.0%
target level in the near-term, and that relative to November"s BoE inflation
report, the risks to inflation now appear more to the upside. Against that
background, the MPC judged that a 25bp hike was necessary to bring CPI inflation
back to its target in the medium term (BoE website).

Going into next week, I think Alan Clarke's comment could be pertinent.

ANALYST COMMENTS

HOWARD ARCHER, ECONOMIST, GLOBAL INSIGHT

"This is a real surprise. Although we had expected interest rates to rise again, we thought the Bank of England would delay acting until at least February when it had a clearer idea of what was happening in the 2007 pay rounds and just how strong consumer spending was over the Christmas and New Year period.


"Clearly, a majority of MPC members believe that recently higher inflation, the buoyant housing market, evidence of ongoing overall relatively robust growth and doubts about the lack of spare capacity in the economy warrants further precautionary action now.

"While we are surprised by the timing of this move, we still believe that 5.25 percent will prove the peak in interest rates this year."

DAVID BROWN, CHIEF EUROPEAN ECONOMIST, BEAR STEARNS

"Never underestimate the Bank of England's penchant for surprise. The Bank of England have caught the markets off their guard with a shock quarter point rate rise, when the market were heading towards expectations of a further move in February or March. Quite clearly the MPC's hackles are up and they are clearly concerned about the recent acceleration in UK inflation to 2.7% and the fast pace of monetary expansion, currently close to a 16-year high. This is a complete anathema to BOE monetary policy sensibilities. We would not be surprised if the tightening bias was still intact as the MPC hawks could be straining on the leash for a further hike to keep inflation risks battened down. This should put further pressure on short-dated UK yields, adding further inversion pressure to the gilt yield curve and giving a further boost to the pound in the process."

ALAN CLARKE, ECONOMIST, BNP PARIBAS

"Major surprise. Given the unusual step of moving outside of the usual inflation report month pattern the market will no doubt speculate that something significant has altered the MPC's thinking and there are more hikes to come.

"The minutes will shed more light on this, but that is still 2 weeks away. At the margins, since the MPC will have known next week's CPI data, we can speculate that the number was high."

KIT JUCKES, HEAD OF DEBT MARKET RESEARCH AT RBS


"The MPC is once again reinforcing its status as the world's most hawkish central bank. The currency obviously benefits from this and it will increase nervousness about what the ECB and the Fed are going to do next. This could tip the balance for a sell-off in stocks and corporate bonds."

LENA KOMILEVA, MARKET ECONOMIST, TULLET PREBON

"By raising rates earlier than expected, the Bank clearly estimates that the inflation risk posed by available data for Christmas consumer spending and pay settlements is greater than they, or the market, had originally estimated."

PHILIP SHAW, INVESTEC

"The statement does not give much detail on precise factors driving today's decision. Our guess would be that some evidence of firmer wage settlements were the main influence behind the timing of the move, although the services PMI last week was probably a significant contributor.

"We're rethinking our interest rate forecasts. The MPC has surprised financial markets twice now within the space of six months and at this juncture it's impossible to rule out another surprise."

PETER DIXON, ECONOMIST, COMMERZBANK

"The rate hike was kind of inevitable but it came a month earlier than expected. That's the bottom line.


"It's the second time the Bank has wrongfooted the markets. The Bank is keeping us on out toes but I can understand why today's move occured.

"The question is now, having acted so quickly, markets are going to be wondering if this marks a more intensive process of monetary tightening.

"Is the Bank going to raise again? That's the question that's going to be ringing round the dealing rooms this afternoon."

MARK MILLER, ECONOMIST HBOS

"It's a very pre-emptive move. The Bank is clearly worried about domestic price pressures."

Comments obtained before the decision:

IAN MCCAFFERTY, CHIEF ECONOMIC ADVISER, CBI

"It is disappointing that, with only tentative indications about the outcome of the wage round, the Bank has already decided to increase interest rates. If part of the intention was to dampen wage increases, it is doubtful a rate rise will have the desired effect.


"Unless wage settlements pick up steeply in coming months, inflation is set to fall back towards the Bank's mid-point target of 2 percent during the second half of 2007. The economy is already expected to slow over the course of the year."

GRAEME LEACH, CHIEF ECONOMIST, INSTITUTE OF DIRECTORS

"This was a tough but wise decision. The MPC needed to stamp down on inflation given the upside risk at present. Inflation is well above target, spare capacity is low, money supply growth is high and the housing market looks perky. Throw in on top the risk of accelerating wage settlements and the Bank of England's pre-emptive strike looks sensible."

DAVID KERN, ECONOMIC ADVISER, BRITISH CHAMBERS OF COMMERCE

"We appreciate the MPC must make difficult choices, and we accept that inflationary pressures have edged up, and the dangers have increased.

"But we believe that the clear risks that growth may slow sharply in both the U.S. and the Eurozone should have been taken more fully into account by the MPC, before tightening policy.

"The MPC could have afforded to wait until trends in the labour market became clearer. If firm evidence emerges that there is no acceleration in wage settlements, the MPC should consider an early reversal of today's increase in interest rates."

IRREPARABLE CRACKS IN THE FINANCIAL SYSTEM by Dr. Marc Faber

A well-respected independent economist and strategist with a bearish trait told me recently that he wished he could be bearish, but that he couldn't find anything that he thought would disturb the asset markets and the global economy in the foreseeable future. Looking at the "real" global economy and at what people produce in terms of manufactured goods and services (ex-financial services), I would have to agree.

Comparing the current global economic expansion, which began in the US in November 2001, with previous economic expansions, it seems to me that the "real economy" isn't showing any signs of the overheating that, in the past, led to aggressive central bank monetary tightening. So, I am, like my strategist friend with the bearish trait, also impressed by the prospects for the global economy. However, I am increasingly concerned about the inflated asset markets around the world, and about the almost unanimous belief that nothing will ever come between the "Goldilocks" economic conditions and the Fed, in conjunction with the US Treasury standing ready to support markets should they decline meaningfully and disturb the current heavenly asset market conditions.

Let us examine the differences between the "real economy" and the "asset inflation economy" more closely. The real economy is typical of people's daily lives, their income, and their spending. If there is a boom in the real economy, wages and prices will tend to increase and the increased demand will be met by corporations' increased capital spending. The overheated economy eventually brings about a slowdown or a recession, because money becomes tight irrespective of the central bank's monetary policies. The recession then cleans up the system and allows the next expansion to get under way. Put very simplistically, this is the typical business cycle.

In the asset inflation economy, we are dealing with a totally different phenomenon. The higher the asset markets move, the more the increased asset prices can create liquidity. Let us assume an investor owns a real estate or stock portfolio worth 100 and that his borrowings are 50. For whatever reason (usually easy monetary conditions), the value of the portfolio now doubles to 200. Obviously, this allows the investor, if he wants to maintain his leverage at 50% of the asset value, to double his borrowings to 100. With the additional 50 in buying power, the investor can then either spend the money for consumption (as the US consumer has done in the last few years) or acquire more assets.

If he acquires more assets, the investor will drive the asset markets - ceteris paribus - even higher, which will allow him to increase his borrowings further. Now, I am aware of some economists who will dispute the fact that rising asset markets create liquidity. They argue that the seller of a portfolio or real estate or stocks at an inflated price will have to be met by a buyer at the inflated price. So, the increased liquidity of the seller is offset by a diminished liquidity of the buyer.

However, the situation isn't quite that simple. Let us assume we are dealing with the market for Van Gogh's paintings, and let's assume that with the exception of just three works, Van Gogh's paintings are all in the hands of museums, foundations, or dedicated art lovers who wouldn't consider selling them except under the most unusual circumstances. Now enter the Russian oligarch who wishes to acquire a Van Gogh at any price.

He might pay double the previous price paid for a Van Gogh, for one of the three paintings still available on the market. As a result of this one buyer, every Van Gogh work will now need to be revalued, and, in theory, all the owners of Van Gogh paintings could now increase their borrowings against the value of those works.

Two works by Van Gogh now remain on the market, one of which a hedge fund manager and an oil sheik from the Middle East both wish to acquire. In a bidding war, they push the price of that painting up another 100% above the previously paid price. Again, all of Van Gogh's works will need to be revalued and their owners can increase their borrowings against them. In other words, the buyers on the margin can move asset markets sharply higher in the absence of ready sellers and thus increase, through the additional borrowing power of the works' present owners, the overall liquidity in the system.

Under normal circumstances, the increased borrowings by the present owners would drive up interest rates. However, in a world of rapidly expanding money supply, this may not be the case. Moreover, which owner of a Van Gogh wouldn't mind paying 6% instead of 4.5% interest on his loans if Van Gogh's paintings were appreciating by 30%, or even 100%, per annum? (This is one reason why the Fed doesn't believe it can control spiralling asset prices with monetary policies.) In the real world, we are not dealing with just one Van Gogh market, but with many asset markets, but the point is that the marginal buyers set the price for assets. It should also be clear that not every owner of a Van Gogh will use his borrowing power and leverage his works of art or other assets.

But if an asset bull market has been in existence for a while, more and more investors will become convinced that the up-trend in asset prices will never end and, therefore, they will increasingly use leverage to maximize their gains. But not only that: lenders will also become convinced that asset prices will rise in perpetuity at a higher rate than the lending rate, and they will therefore relax their lending standards.

This certainly seems to have occurred in the sub-prime lending industry.

There is one more point to consider. Liquidity isn't evenly distributed.

Let's say that on an island there are two tribes. Ninety-nine percent of the population are the "Bushes" and 1% are the "Smartos". The two tribes arrived on the island at about the same time and had little capital at the time. So, initially, both tribes worked very hard in industry and in commerce to acquire wealth. But because of the Smartos' superior education and skills, their frugality, and also partly because of their greed and immorality, they soon acquired significantly more wealth than the Bushes, who, for the most part, were likeable but quite inept. After 50 years, most of the island's businesses were therefore in the hands of the Smartos, who make up just 1% of the population. Being clever, the Smartos generously gave some of their wealth to the tribal leaders of the Bushes, who controlled the entire government apparatus, the military establishment, and much of the land.

For a while this system functioned perfectly well. Among the Bushes there were also some smart people, and they were encouraged to accumulate wealth as well. However, they had to pay an increasingly high price to acquire assets, since most of the island's assets were owned by the Smartos and by the elite of the Bushes who, because of their wealth, never really had to sell any assets. Cracks in the system began to appear because more and more of the wealth began to be increasingly concentrated in fewer and fewer hands. (According to the Financial Times, the concentration of wealth is extremely high in the United States, with 10% of the population currently holding 70% of the country's wealth, compared to 61% in France, 56% in the UK, 44% in Germany, and 39% in Japan.)

However, the Smartos then stumbled upon another avenue to wealth:

globalization. The island was opened to foreign trade and investments, which allowed the business owners to shift their production to low-cost foreign countries and, at the same time, to keep the masses among the Bush tribe happy through the imports of price-deflating consumer goods. In the same way that, in the 18th and 19th centuries, the European settlers of America had exchanged with the Indians worthless beads and booze for land, now the Smartos and the elite of the Bushes exchanged cheap imported goods, whose supply they controlled and from which they earned handsome margins, for assets. As a result, the majority of the population of the Bushes experienced a relative wealth decline compared to the wealth of the Smartos.

Again, this worked perfectly well for a while: the populace was happy to buy deflating consumer goods (like Mr. Faber's wife who, whenever a favorite shoe store holds a sale, immediately buys three pairs instead of one), but it overlooked the fact that its wages and salaries were decreasing in real terms because manufacturing jobs and tradable services were increasingly shifting overseas. For some time this wasn't a problem, because the Smartos had bought the island's central bank.

They made sure that sufficient money was made available to the system to sustain the consumption binge, which was largely driven by inflating asset prices. Plenty of liquidity and rising asset prices created among the Bushes the "illusion of wealth". Naturally, the island's trade and current account deficit began to worsen as it consumed significantly more than it produced, but initially that wasn't a problem, for the Smartos had encouraged the Bushes to engage - in the name of all kinds of good, just, and well-meant causes, and without any self-interest whatsoever - in overseas military expeditions, which led foreign creditors to believe in the island's economic and military might, and social stability.

For a time, they were, therefore, perfectly happy to finance the island's growing current account deficits. At the same time, the increase in defense spending shifted wealth from the masses to the elite of the Bushes, who largely controlled the military hardware and procurement industries. As a result, wealth and income inequity widened further as the masses became largely illiquid and had difficulty in maintaining their elevated consumption, while the Smartos and the elite of the Bushes accumulated an ever-increasing share of the national wealth. But never at a loss when it came to creating additional wealth, the Smartos devised another scheme to enrich themselves even further: lending to illiquid households (read sub-prime lending). Not that the Smartos would have lent their own money to these uncreditworthy individuals (they were far too clever for that); for a fat fee, they arranged and encouraged this novel type of financing. Credit card, consumer, and mortgage debts were all securitized and sold to pension funds and asset management companies whose beneficiaries were the majority of Bushes, who accounted, as indicated above, for 99% of the population.

In addition, these securitized products were sold to some credulous foreign investors. By doing so, the Smartos achieved three objectives.

They earned large fees, and unloaded the risks indirectly on to the very people who borrowed the money, and on to foreigners. But most importantly, they provided the Bush tribe with a powerful incentive to support their expansionary monetary policies, which ensured continuous asset inflation.

After all, any breakdown in the value of assets would have hurt the Bushes the most, since they carried most of the risks by having purchased all the securitized lower-quality financial instruments. But not only that! The Smartos knew that as asset prices increased, their prospective returns would diminish.

But this wasn't an immediate problem, as they promoted increased leverage to boost returns to the investors and at the same time their own fees.

This strategy worked, of course, for as long as asset prices appreciated more than the interest that needed to be paid on the loans. On first sight, the debt- and, consequently, asset inflation-driven society of the island seems to work ad infinitum. But in the real world this isn't the case. Sooner or later, the system becomes totally unbalanced and entirely dependent on further asset inflation to sustain the imbalances. It is at that point that even a minor event can act as a catalyst to bring down asset prices and produce either "total", or at least "relative", illiquidity in the system, because a large number of assets whose value has declined no longer cover the loans against which they were acquired.

"Total illiquidity" occurs when the central bank, faced with declining asset prices, doesn't take extraordinary measures to support asset prices.

"Relative illiquidity" follows when the central bank implements, in concert with the Treasury, extraordinary monetary and fiscal policies (cutting short-term interest rates to zero, and the aggressive purchase of bonds and stocks) in a desperate effort to support asset prices. In both cases, a degree of illiquidity occurs and depresses asset prices, but in different ways. In the case of "total illiquidity" (1929-1932 and Japan in the 1990s), asset prices tumble across the board in nominal and real terms with the exception of the highest-quality bonds and, possibly, precious metals (flight to safety). In the case of the island's central bank taking extraordinary monetary measures, asset prices don't necessarily decline in nominal terms, and in fact can even continue to appreciate.

However, they collapse in real terms, and against foreign currencies and precious metals. How so? Above, we have seen that the island's asset inflation led to excessive consumption and to growing trade and current account deficits because the Smartos and the elite of the Bushes were quick to understand that much larger capital gains could be obtained by playing the asset inflation game and by manufacturing overseas, than by investing in new production facilities and producing goods on the island.

The growing trade and current account deficits of the island were not immediately a problem, because they were offset by external surpluses in other parts of the world, which were frequently and erroneously labeled as "surplus savings" or a "savings glut". But whatever one wishes to call these surpluses or reserves, it is interesting to note that where they accumulated (mostly in China, Japan, Taiwan, Singapore, and Switzerland), they led to an interest rate structure that was lower than on the island.

For the Smartos, this was an extremely fortuitous condition. For one, it was easy to convince the recipients and holders of these rapidly accumulating reserves to invest them in higher yielding assets on the island. In addition, it was for a while extremely profitable to borrow in low-yielding foreign currencies and to invest in relatively high-yielding assets on the island.

Obviously, this all changed when asset prices began to decline and the island's central bank had to take extraordinary measures by aggressively cutting short-term interest rates and supporting asset markets through bond and stock purchases. The interest rate cuts immediately narrowed the spread between the interest rate on the island and foreign currencies and led to a run on the island's currency, not only by foreigners but also by the Smartos, who had known all along that the asset inflation game would one day come to a bitter end. The deleveraging of this carry trade led to "relative illiquidity", which the island's central bank had to offset with even more liquidity injections, which while stabilizing asset prices led to even greater loss of confidence in the soundness of the island's currency, and in its bond market, which by then was mostly owned by foreign creditors.

As Mao Tse Tung had observed much earlier, there was by then "great disorder", but the situation was "excellent" for the Smartos. On the short end, interest rates had been cut so much that they were in no position to compensate for the continuous depreciation of the island's currency. So, the Smartos and the Bush tribe's elite began increasingly to borrow in the island's currency and to invest in foreign assets and precious metals. In fact, the island's central bank, by its market-supporting interventions, encouraged this process. Stocks and bonds were dumped on to the central bank and the Treasury's plunge protection team at still high prices, and the proceeds were immediately transferred to foreign assets and precious metals, which appreciated at an increasing speed compared to the island's assets, which suffered from the continuous depreciation of the currency.

And in order to facilitate this trade, the Smartos, who controlled both the Fed and the Treasury, continued to make positive comments about "a strong currency being in the best interest of the island". Sure, it would have been in the best interest of the island to have a strong currency, but it was certainly not in the best interest of the Smartos, who had devised their last grand plan: shift assets overseas and into precious metals, let the currency of the island collapse, and then repatriate the funds and buy up the remaining assets of the Bush tribe's middle and lower classes at bargain prices since they had never understood that their currency had collapsed against foreign currencies and against gold.

Regards,

Dr. Marc Faber

for The Daily Reckoning