By Mike Whitney

URL of this article: www.globalresearch.ca/index.php?context=va&aid=15919

Global Research, November 4, 2009

Interest rates. The Fed does not need slinky women in plunging
necklines to peddle money. All it needs is low interest rates. When
rates are pushed lower than the rate of inflation, the Fed provides
a subsidy for borrowing. This is not as hard to grasp as it sounds.
If I offered to give you $1.00 for very 90 cents you gave me in
return, you would buy as many dollars from me as you could. The Fed
operates the same way. It generates market activity by creating
incentives for borrowing. Borrowing leads to speculation, and
speculation leads to steadily rising asset prices. This is how the
game is played. The Fed is not an unbiased observer of free market
activity. The Fed drives the market. It fuels speculation and
controls behavior by fixing interest rates.

When Lehman Bros flopped last year, markets went into freefall. A
sharp correction turned into a full-blown panic. The bubble burst
and trillions of dollars in credit vanished in a flash. Trading in
exotic debt-instruments stopped overnight. A global sell-off ensued.
Markets crashed. For a while, it looked like the whole system might
collapse.

The Fed's emergency intervention pulled the system back from the
brink, but the economy is still wracked with deflation. Billions
in toxic waste now clog the Fed's balance sheet. The dollar has
fallen like a stone.

When the financial system blows up and credit is sucked down a
capital-hole, the economy goes into a downward spiral. Businesses
slash inventory and lay off workers, workers have to cut back on
spending and credit. That creates less demand for products, which
leads to more lay offs. This is the vicious circle policymakers try
to avoid. That's why Fed chair Ben Bernanke wheeled out the heavy
artillery and launched the most aggressive central bank intervention
in history.

The Fed dropped rates to zero, but its Quantitative Easing (QE)
program (which monetizes the debt) actually pushes rates even lower
to roughly negative 2 percent.

Bernanke has underwritten every sector of the financial system with
government guarantees. He has provided full-value loans for dodgy
collateral which is worth only a fraction of its original value.
The market can no longer operate without the Fed. The Fed IS the
market, which is why it is foolish to talk about a "recovery". The
idea of recovery implies a free-standing system based on supply and
demand. But, for now, the government provides the demand, which is
why there is no market and no recovery. Analysts at Goldman Sachs
sum it up like this:

"How much of the rebound in real GDP was due to the fiscal stimulus,
and where do we stand in terms of the effects of stimulus thus far?
Although precise answers are impossible at this juncture, several
aspects of the report are consistent with our estimates that the
fiscal package enacted in mid-February as the American Recovery and
Reinvestment Act (ARRA) would have accounted for virtually all of
the growth reported for the third quarter."

(http://www.zerohedge.com/article/hedging-their-bets)

Positive growth is an illusion created by government spending. The
economy is still flat on its back. Consumer spending and credit are
in sharp decline.

Unemployment is steadily rising (although at a slower pace) and
wages are flatlining with a chance of falling for the first time
in 30 years.

Deflationary pressures are building. The talk of a "jobless recovery"
is intentionally misleading. Jobs ARE recovery; therefore a jobless
recovery merely points to asset-inflation brought on by erratic
monetary policy.

Surging stocks shouldn't be confused with a genuine recovery.

The Fed faces stiff headwinds ahead. Low interest rates can have
unintended consequences. The "cheapness" of the greenback has made
the dollar the funding currency for the carry trade. Investors are
borrowing low cost dollars and using them to purchase higher interest
assets elsewhere. The process, which is rapidly escalating, is
fraught with peril as economist Nouriel Roubini points out in an
article in the Financial Times:

"Since March there has been a massive rally in all sorts of risky
assets... and an even bigger rally in emerging market asset classes
(their stocks, bonds and currencies). At the same time, the dollar
has weakened sharply, while government bond yields have gently
increased but stayed low and stable...

But while the US and global economy have begun a modest recovery,
asset prices have gone through the roof since March in a major and
synchronized rally...

Risky asset prices have risen too much, too soon and too fast
compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped
by a wave of liquidity from near-zero interest rates and quantitative
easing. But a more important factor fueling this asset bubble is
the weakness of the US dollar, driven by the mother of all carry
trades. The US dollar has become the major funding currency of carry
trades as the Fed has kept interest rates on hold and is expected
to do so for a long time. Investors who are shorting the US dollar
to buy on a highly leveraged basis higher-yielding assets and other
global assets are not just borrowing at zero interest rates in
dollar terms;

they are borrowing at very negative interest rates...

Every investor who plays this risky game looks like a genius  even
if they are just riding a huge bubble financed by a large negative
cost of borrowing...

...This policy feeds the global asset bubble it is also feeding a new US asset
bubble...

The reckless US policy that is feeding these carry trades is forcing
other countries to follow its easy monetary policy... This is keeping
short-term rates lower than is desirable... So the perfectly
correlated bubble across all global asset classes gets bigger by
the day.

But one day this bubble will burst, leading to the biggest co-ordinated
asset bust ever: if factors lead the dollar to reverse and suddenly
appreciate...

the leveraged carry trade will have to be suddenly closed as investors
cover their dollar shorts. A stampede will occur as closing long
leveraged risky asset positions across all asset classes funded by
dollar shorts triggers a co-ordinated collapse of all those risky
assets  equities, commodities, emerging market asset classes and
credit instruments." ("The Mother of all Carry Trades Faces an
Inevitable Bust", Nouriel Roubini, Financial Times)

Everyone who watches the market has noticed the inverse correlation
of stocks to the dollar. When the dollar fades, stocks soar. And
when the dollar strengthens, stocks plunge. Eventually, the dollar
will reverse-course and stage a comeback, probably when Bernanke
stops his printing operations. That will trigger the next severe
correction which will burst bubbles across all asset classes.

Bernanke's success in reflating sagging asset prices has depended
entirely on interest rate manipulation and liquidity injections.
There's been no effort to patch household balance sheets, increase
production, or strengthen overall demand. It's a clever trick by a
master illusionist, but it has its costs.

When the dollar rallies, markets will crash. And Bernanke will be
responsible.

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Copyright Mike Whitney, Global Research, 2009

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