Cash Put on Notice

The money flood is coming; it's time to build your ark...

IF CENTRAL BANKS worldwide are worried about economic health and the chance of recession, we can't see how providing more "liquidity" will do the trick, writes Dan Denning from Melbourne, Australia, for The Daily Reckoning.

Remember, over-leveraging is the problem. That's what needs to be reduced. Does providing cheaper credit – right back at 1% per year for US Dollars – reduce leverage? Hmm. No.

The Federal Reserve now has just a few bullets left in its interest-rate gun. Pop! Pop! It will save those for an emergency. Think of the scene in Aliens when Hicks and Ripley are being chased in air duct by the creepy crawlies.

"Hicks, don't let one of those things get me," Ripley says.

"Don't worry. If it comes to that, I'll do us both," he answers.

Inflation, deflation, insolvency, lack of liquidity, deleveraging...so many battles for the Fed to fight. So few bullets.

The nuclear game changer in all this is now fiscal policy, a.k.a. government spending. And there's no guarantee, by the way, that Senator Obama and his 21st century vision of the Great Depression's "New Deal" will win next Tuesday. The American media has made the huge mistake of inflating expectations of his victory by releasing all sorts of suspect polling data.

The pollsters try to influence voting as much as they try to predict it. In fact, in their "rah-rahing" for Obama, the media has set up a really nasty backlash if Senator McCain somehow wins in Florida, Ohio, Pennsylvania, Virginia, and Colorado. It will appear to the average Joe Six Pack that the only way McCain could have won was to cheat, or because Americans are racist behind closed doors.

If Obama doesn't win, there are going to be some pretty unhappy people in the streets of Chicago (and Berlin, and San Francisco, and Melbourne). But our point is that from a short-term economic perspective, it doesn't really matter who wins. There's going to be a big stimulus package passed in Washington.

Just how big and who will pay for it, who knows? But if investors are looking for something to improve their expectations for the economy and earnings, it's either more splashy government spending...or nothing else we can think of.

You might have missed it, but the yield on the 30-year US government bond just plunged to its lowest level since the Feds began selling them in 1977. On Oct. 24th, the yield on the 30-year dipped to 3.86%. Since then, however, it's been rising. What could this mean?

Well, it could mean that the last great bubble in the world today – the bubble in US government debt – is bursting. Why? Bond investors aren't generally stupid. Everyone in the world has flown into Treasuries for safety as the Dollar-Yen carry trades collapsed and forced de-leveraging crushed stocks everywhere.

Plus, if you were a big seller of commodities or emerging market stocks you'd purchased with borrowed dollars, you have to put those dollars into something (if you're not paying them back that is). Treasuries, of which the US government has been supplying plenty, were the preferred investment. Unlike money market funds (or say, mortgage funds), Treasuries ARE government guaranteed. But now, bond investors see the Fed cutting rates back to just 1%. They see plans for a massive New Deal 2.0 under a Democratic Congress and an Obama administration. And they see yesterday's report from the International Energy Agency saying that global oil production may not keep up with demand without massive new investment.

And what do investors conclude? That after the markets have finished de-leveraging, you'll have a new status quo in the world. The supply of government debt is on the rise. Governments are stimulating faster than a harem of masseurs in a Thai massage parlor. The respective adjusted monetary bases of the world are expanding. The money flood is coming! It's time to build your ark.

You don't want to own bonds or much in the way of low-yield fixed income when the money supply grows. That's because inflation will eat away at your investment. So the stage is set, we believe, for the rotation out of cash and bonds and back into the only asset class that will outperform during inflation – stock-market equities.

In this, we here at The Daily Reckoning agree with Warren Buffett. Investing in equities at this point is like emerging from a bomb shelter to find the streets of the town deserted...and littered with quality companies – especially energy and resource stocks – that have simply been dropped in the street as investors ran for the hills.

All you have to do is dust them off and put them in your pocket. You hope they aren't radioactive, of course. Which is to say, you hope Nouriel Roubini isn't right and that S&P 500 isn't going to fall by another 30% or the ASX by another 25%.

But the penalty for being too much in cash could be severe. That's IF we're right and the growth in global adjusted monetary base is inflationary. But the commodity markets might be signaling that it is.

Copper was up 12% yesterday and oil 5%. When you compare these stirring in the commodity markets with (what we believe) was the pricking of the bond bubble last week, you have signs of a slow leak in the bond bubble...leading directly rising prices for real assets.

Money will bleed out of bonds and cash and into the most overly-sold producers of tangible assets, as well as their output. No, it's not a risk-free trade. But then again, what is risk free these days? Even doing nothing but being in cash is an action with risk. So the question today is where lies the next danger to your money: inflation or deflation?

And what is the best way to avoid the danger, preserve your capital, and profit...come what may?

Neither are easy questions. It depends on how much de-leveraging still needs to be done by banks and hedge funds. But keep your eye on the bond markets and – more crucially – on commodity prices. They are flashing warning signs of inflation.

Cash should take notice.