But here’s the story in a nutshell. Li Lianzhong, a senior economist in the ruling Chinese Communist Party, directly attacked the dollar yesterday. Li’s message is simple: China should buy more gold because the dollar is poised for a fall. Li also said that China should use more of its $1.95 trillion in foreign reserves to buy energy resource assets.

Speaking at a forex and gold forum, Li asked the very valid question, “Should we buy gold or U.S. Treasurys? The U.S. is printing dollars on a massive scale, and in view of that trend, according to the laws of economics, there is no doubt that the dollar will fall. So gold should be a better choice.”

There is no doubt in our minds that China – the largest holder US Treasurys with $763.5 billion worth of bonds at the end of April – is maneuvering to reduce its exposure to the buck.

China has already said it will buy up to $50 billion worth of bonds denominated in Special Drawing Rights. These are essentially potential claims on freely usable currencies issued by the International Monetary Fund.

And on April 24, China revealed it had increased its holdings of gold to 1,054 tons from 600 tons since 2003.

Charles Delvalle offers another way to protect yourself from a dropping buck. Charles reckons that as the dollar has lost value the stock market has risen. In a recent e-mail to the crew at Notes he said…

“As long as the dollar isn’t dropping catastrophically then a falling dollar may actually be good for the stock market. Since March 9th, while the stock market has increased over 25%, the dollar has lost 10% of its value. What this shows is that as long as the dollar isn’t dropping catastrophically then a falling dollar may actually be good for the stock market. It means that the velocity of money is increasing. In other words, cash is moving out of bank accounts and into the markets.

“So one way to play a falling dollar is by going long the market. My suggestion is to buy into the strongest index right now, the Nasdaq. You can do that by buying shares of the Powershares Exchange Traded Fund (QQQQ) which tracks the Nasdaq.

“Another way to play a weaker dollar is by betting that the currency itself will fall. You can now do that easily thanks to ETF’s. One ETF which increases in value as the dollar drops is the PowerShares DB US Dollar Index Bearish (UDN).

Well… The currencies continue to trade heavy under the pressure of the dollar, and the “flight to safety” in Treasuries… The euro has lost the 1.26 handle and continues to look weaker and weaker all the time. The latest move down came as a result of new that Eurozone leaders rejected a request for Eastern Europe aid… Here’s the skinny on that…

Hungary had proposed that Eastern European countries like themselves, Poland and the Czech Republic, receive loans totaling 180 Billion euros ($227 Billion dollars worth) from the Eurozone… Shot down….. I don’t want to be… Shot down! Ahhh, a little April Wine this morning… But getting back to this latest development, this news of a rejection, leaves the Eastern European countries hanging, and trading this week, or until something changes, outside the euro… In other words, the Eastern European Countries, like Hungary, and the other two mentioned above, normally trade partially on their own, and partially with the backing of the euro, since these three particularly were once considered to be on the “fast track” to euro conversion.

So… Not only do the Eastern European currencies get taken to the woodshed, in today’s environment with bailouts being the norm, the euro gets taken to the woodshed too for not “bailing out” their brothers…

This is what we’ve come to folks… If you’re not going deeper in debt, and bailing everyone and their brother, nobody likes you any more! I read one person’s thought on the Eurozone rejection, and they immediately stuck a knife in the Eurozone, saying “this shows European countries are behind the curve. They are acting against a global crisis with national measures.” Hmmm… Ward… You were a little hard on the Beaver last night, weren’t you?

The other BIG NEWS this morning was a report that John Taylor, who manages $11.4 Billion as chairman of New York-based FX Concepts, Inc. Let’s listen in… “Whenever a banking system realizes it’s in big trouble, it says, I have to take care of my next door neighbors and the businesses down the block. Then the currency of that country, it its banks are big in international lending like the U.S., will strengthen.”

Needless to say, but, it certainly sounds like Mr. Taylor, has drunk the kool-aid, and is buying dollars along with the others seeking a “safe haven”…

I tell you this, because, someone wrote me recently, and said that I only print commentaries that agree with my stance… So there! This guy is HUGE, and he’s buying dollars!

Well, the revision to 4th QTR GDP printed much worse than forecast on Friday… Let’s see what the Wall Street Journal had to say about it… “Gross domestic product decreased at a seasonally adjusted 6.2% annual rate October through December, the Commerce Department reported in a new, revised estimate of fourth-quarter GDP. The sharply lower revision reflected adjustments downward of inventory investment, exports and consumer spending.

The 6.2% decline meant the worst quarterly showing for GDP since a 6.4% decrease in first-quarter 1982 GDP.

But… With like all “bad data” in recent times, the traders flocked to the dollar and U.S. Treasuries… Makes no sense to me, but then, I think logically… Not like some Ivy leaguer that never spent time in the mail room, learning the business from the bottom up… Wait! How did that thought go into my feelings about one of the reasons this mess is so bad? I was saving those thoughts for a “rainy day”… Oh well, there’s a hint as to where that discussion might go, when I decide to really “let loose”!

Obviously, a decline of 6.2% is pretty dis-heartening for those that believe the recession will be V-shaped… Buzzzzzzzz! Thank you for playing, there’s a nice parting gift for you at the door!

The data cupboard is stocked and ready to yield a plethora of data this week! We start today with Personal Income and Spending, and end the week with the Jobs Jamboree, in between we’ll see the ISM Index (manufacturing), Pending Homes Sales, the Fed’s Beige Book, and more! So, we won’t be void of data to talk about this week.

It looks like January will be the month that sees jobs losses greater than 600K, as the “experts” have forecast the total job loss for January at 650K! Aye, Yay, Yay… That’s just awful! The unemployment rate is expected to hit 7.9%, but don’t be surprised if it prints a snowman… That’s an 8 for you non-golfers, bad golfers I should say! I still believe that the unemployment rate will reach 8.5% before this is all over, and that’s even taking into consideration that Obama’s Stimulus is a smashing success! (here’s the kicker though, that no one’s talking about regarding these jobs that will be created by the Obama stimulus… For the most part, they will all be “short-term jobs”. What happens when those “short-term jobs” end?)

OK… Enough! The data will print when it prints, so I’ll just leave it there…

Back to Treasuries for a minute… A reader sent me a note that the 5-year Treasury auction priced at 1.92% yield… So, why the attraction to Treasuries? 1.92% for a 5-year Treasury? That’s pitiful! And if the continued buying at that level doesn’t represent an “overbought” situation than I’m not bald, overweight and short!

The Canadian dollar / loonie had a rough go of it on Friday after their Current Account printed as a deficit for the first time since 1999! So… After 9 years of surpluses, Canada is dealing with a deficit… The Current Account deficit totaled a seasonally adjusted C$ 7.486 Billion in the fourth quarter, bigger than the consensus forecast for a C$ 5.1 Billion shortfall. A slump in the goods trade account combined with a widening investment income deficit resulted in the largest Current Account deficit since 1993.

Japanese yen continues to weaken from it’s lofty levels of just a couple of weeks ago… I tried to point this out to everyone when I said that the Unwinding of the Carry Trade looked as though it had come to an end… If the unwinding involved buying yen, then the end of the unwinding would involve not buying yen… Then when it stops getting stronger, profit taking begins, and… Well, that’s where we are today with yen…

Remember last week when I mentioned that AIG could post the largest loss in U.S. Corporate history at $60 Billion? Well, they bettered that number posting a loss of $61.66 Billion! So… Guess who stepped in again to make sure they didn’t fail? That’s right! The U.S. Gov’t… Here’s the skinny as reported by the Wall Street Journal… “The federal government has revamped its rescue package to American International Group and will provide the troubled company another $30 billion, with the Treasury saying AIG continues “to face significant challenges.” The announcement comes as the insurance giant posted a $61.66 billion net loss for the fourth quarter.

The new package comes as the company has burned through cash and has been unable to find buyers for pieces of its company that it hoped to sells to repay the government on its existing loan package, which totals some $150 billion.

>>>> back to me… I tell you this folks… I truly believe that the Gov’t might as well find a big black hole and throw the $30 Billion into it, because now AIG is at $150 Billion in total loans, and still burning through cash… I hope I’m wrong, because as a taxpayer, I would hate to see this, but… I think we’ll hear about more Tens of Billions being put into this company in the future…

Speaking of taxes… I met my guy on Friday to begin the tax accounting process… The time is slipping by pretty quickly folks, and April 15th will be here before we know it!

I’ve talked about how much I enjoy reading Caroline Baum’s articles on Bloomberg before… And she has one now that really strikes a nerve with me, in that for once I have someone agreeing with me that the latest stimulus isn’t addressing the problem with the banks… Here’s a snippet…

“Fed Chairman Ben Bernanke said in congressional testimony last week that key to stabilizing the economy is stabilizing the financial system.

If that’s the case — and policy makers of all stripes seem to agree that it is — why a $787 billion fiscal stimulus bill filled with political priorities and a budget that increases domestic spending by 8 percent?

As an economist friend of mine says, you can’t force-feed someone who’s in the middle of coronary thrombosis.

Better to make the treatment fit the disease. Revamping the health-care system won’t fix the banks. Raising the price of carbon-based fuels and force feeding the nation alternative sources of energy won’t loosen up lending. And higher taxes on the wealthy, and inevitably the not-so-wealthy, won’t enhance bank solvency.

Doing so many things at once means a reduced focus on the root of the problem. There’s a reason the tortoise beats the hare in Aesop’s fable.”

The entire story can be read here, and I highly recommend that you do… http://www.bloomberg.com/apps/news?pid 601039&sid aoKaIpGop7No&refer columnist_baum

Currencies today 3/2/09: A$ .6325, kiwi .4935, C$ .7785, euro 1.2580, sterling 1.4150, Swiss .85, rand 10.3685, krone 7.20, SEK 9.22, forint 243.50, zloty 3.78, koruna 22.62, yen 97.10, sing 1.5540, HKD 7.7565, INR 51.94, China 6.8450, pesos 15.40, BRL 2.4120, Dollar index 88.72, Oil $42.38, Silver $13.10, and Gold… $946.55

Source: Saying “NO” To Eastern Europe

This from The Sovereign Society:

In the last few weeks, Treasury yields have been headed upward – from 2.63% a month ago to 3.33% today on 30-year bonds – and everyone’s been asking whether the bubble has finally blown out.

The “Treasury Bubble” became the new boogeyman for many experts and media pundits last year. Its “impending” collapse could potentially crush the U.S. government and throw the dollar into rampant hyperinflation.

But is it a bubble at all? And if so – or not – what’s your most prudent course of action?

That’s what we’ll be talking about today, on the heels of Ben Bernanke’s latest announcement that he’d consider purchasing long-dated bonds in the open market to manipulate yields. Will Bernanke’s plan be the final nail in the coffin for the U.S. economy and the dollar, or will it further propel a 27-year bull market in Treasuries?

Just the Facts…

That we’ve been in an almost thirty-year bull market for Treasuries is perfectly clear.

Since October of 1981, when yields hit 15.21% on long-term bonds, Treasury yields have been on a downward trend. And aside from a few reversals in that span of time, yields have consistently been lower each year.

But Bill Gross – Manager of PIMCO’s Total Return Fund – admits that the Treasury market is showing “some bubble characteristics,” and reiterates a previous statement, “…I have said for the past three months, the governments are very overvalued.” Do Gross’ cautious statements back up the allegations of Peter Schiff and other “Treasury Bubble” proponents?

The very essence of a bubble is that it’s unsustainable in the long run. So let’s ask the question; what happens if this bull market continues and 30-year government paper reaches a yield of zero?

Sustained rates at that level would indicate the market’s belief that we’re in a deep depression. Essentially, the market would be saying that it would rather park money with the government for 30 years – with a guaranteed return of zero – than risk it in private-sector investments. Retirement fund managers would be forced either to adjust their expected returns or abandon Treasury debt altogether.

But investors in zero-yielding Treasury paper would actually be taking on more risk than they might expect. And that’s the risk of a rising interest rates…

Interest Rate Risk

Even if Treasury yields reach zero, it’s not likely they’ll stay there forever. And when yields once again start to rise, it puts the capital investment of bondholders at risk.

Let’s say for example that Treasuries are yielding zero and you purchase a US$1,000 dollar note without any discount (so you’re paying US$1,000 for the bond). Then, rates eventually rise to 1%. That means that buying the same bond will only cost you US$990, even though you’ll still be reimbursed the full US$1,000.

That means you’ve essentially lost 1% of your original capital investment, as the market price of your bond would change to reflect the new issue yielding 1% more than your original purchase. As you can imagine, the lower yields get, the greater the risk to an investor’s capital is likely to be.

The “Treasury Bubble” and YOUR Money…

It’s hard to tell whether Treasuries are currently in “bubble” mode.

Unfortunately, most bubbles just aren’t diagnosed until after-the-fact. While they’re clear in hindsight and defining “unsustainable” levels is easier after the bust, the real defining attribute of a bubble is the rampant sell-off and ensuing havoc that come once the bubble has popped.

So should you join in with the “Bubble-phobia” and steer clear of Treasuries?

It’s a good idea to steer clear of Treasuries right now, but not because the Treasury-bubble-boogeyman is hiding under your bed. Simply put; the interest rate risk seems far too great for the meager reward of near zero-yielding Treasury securities. In light of the news, we can safely expect Bernanke to do everything in his power to suppress that long end of the curve. And we can probably expect the market – in turn – to continue to disagree, leaving Treasuries in a relatively volatile position.

Instead, Investment Director Eric Roseman believes there’s a case for select issues of Investment-Grade Corporate debt. It’s also a great time to look at gold, “With interest rates now at 0%,” Eric recently said, “the cost disadvantage to holding gold has vanished because high quality Treasury bond yields have plummeted while T-bills pay nothing. Gold will probably safeguard your capital better than paper money in this environment.”

Source: The End of the Treasury Bubble?

The forces of the universe are pulling against one another. Tomorrow at noon, the nation will gain a leader that has inspired hope in millions of Americans. Economically, Obama’s stimulus plan is viewed as the last chance to keep the nation’s economy from retreating to a full-on depression.

I will be watching closely to see if Obama’s 6-foot-1-inch body shrinks at the exact moment he places his left hand on the bible as the weight of numerous global crises is piled on his back. It will take one heck of a leadership team to get us out of this financial mess. We had better hope Obama is as good as his campaign (and the mainstream media) says he is.

With the huge events in Washington this week, Wall Street is going to be devoid of attention. With numerous major companies expected to release quarterly earnings this week, that may be the best news we heard in a while. Any widespread bad news could send the equities market plunging once again. It may be best if the results stay quiet.

What to watch

Some key items to watch this week will be crude prices, the dollar and, of course, those pesky earnings reports. The crude markets are in for a wild ride as reserves across the nation begin to fill to maximum capacity. With demand down and suppliers hoarding their oil until prices rise, we are quickly running out of room to store the energy. If supplies are not significantly reduced in the very near future, crude prices could plunge below the $30 mark. It may happen this week.

With central banks cutting interest rates and news that England is putting several billion more pounds into its banking industry, the currency markets are likely to be busy over the next few days. That means the dollar, which has strengthened recently, could make even more gains. That is good news for a country that imports just about everything it needs.

Finally, with Blue Chips like Johnson & Johnson (NYSE:JNJ) and International Business Machines (NYSE:IBM) releasing their latest results tomorrow, all eyes will be on the lookout for major surprises. We got just a glimpse of the horrific potential this earnings season possesses last week. It caused share prices to plummet across the board. Traders will be hard-pressed to take the markets drastically lower without the news of a financial Armageddon, but if it is going to happen, it will happen this week.

Some plays worth taking a look at are Johnson and Johnson and the gold market. If JNJ releases earnings of better than $0.93 per share, expect a sizeable surge, making call options a worthy investment. Even if the company misses expectations by a penny or two, do not expect a wild swing to the downside, especially after giving up a few dollars in share price last week.

With the dollar in play and investors starting to look for safety outside the less-than-lucrative Treasury market, gold is getting plenty of attention. The precious metal gave back some of its recent gains last week, but showed signs of life late in the week. If earnings season turns sour, expect a bullish run.

This is going to be a news-filled and hectic week. Investors will have more than enough to digest. Smart traders will understand the news, conceive a strategy and profit as the nation jukes and jives through this critical period.

It will be an interesting few days.

Source: The news will dominate Wall Street this week

This from Taipan Daily:

Has the U.S. Treasury bubble popped? It’s starting to look that way.

USTs gapped higher in mid-December, traded in a quiet range til year’s end, and then immediately went into freefall with the start of the new year.

This wasn’t a total surprise. On Dec. 23rd, in a Taipan Daily piece titled “A Treasury Bond Mystery and a Currency Clue,” I gave a summation of what was happening and how to play it:

Based on end-of-year accounting factors and a supply-limited window of foreign investor buying, USTs could be a good candidate for a quick, sharp break (much like the dollar’s swift fall) early in the 2009 calendar year.

An aggressive put option trade – near-term firecrackers relatively close to expiry – could be one way to play this. If done right, it’s the kind of trade where you either lose the small amount you invested or make five times your money in a fingersnap.

There were multiple trading days available to follow up on that hunch. If you chose to act on it with near expiry options as I suggested, you should be sitting on some very nice gains right now.

With that in mind, I still stand by the rest of what I said in that piece:

If I were to make a short-term play like this, I would do it with money I could afford to lose – probably no more than one or two percent of my total trading account. And if the trade paid off, I would take the money and run at the first sign of stabilization (rather than waiting around for the Fed to bid bonds up after the break).

The Yogi Berra Effect

Now, it may well be that treasuries keep tumbling. But this isn’t a trade I would look to build on… at least not for now. As I said two weeks ago, I’d pocket the cash sooner rather than later.

Why? For one, the play just feels too damn obvious now. Everyone and their brother “knows” treasuries are overvalued.

That kind of consensus makes me nervous as a long-tailed cat in a room full of rocking chairs, and Barrons heightened the feeling by putting USTs on their Jan. 5th cover. Get Out Now! the Barrons headline blares.

“The bubble in Treasuries looks ready to pop,” the lead piece goes on to add, “sending prices on government debt sharply lower.”

With the whole Barrons yelling “Get Out Now!” bit, I can’t help but think back to some famous old Economist covers, two of which I have framed. “Drowning in Oil” and “The Disappearing Dollar” both marked major trading bottoms. When a view becomes conventional wisdom – or popular enough to merit cover treatment – odds increase that the news is fully discounted.

It’s the Yogi Berra effect, slightly modified for markets: “Nobody’s in that trade anymore, it’s too crowded.”

Reasons to Be Wary

Another factor that makes me nervous, as I also mentioned in December, is the Fed.

Falling treasuries mean rising interest rates. The Fed doesn’t want rising interest rates… especially when the central banker worry du jour is deflation.

And speaking of deflation fears – which are tied to factors like forced saving, canceled business, and overall economic contraction – how about the recent ISM data?

As the above FT chart shows, ISM readings for both new orders and prices paid just hit their lowest levels in more than half a century. Evidence further shows that manufacturing has slowed markedly all around the world.

In other words, the threat of global slowdown still looms large. If the current market rally is just a trading rally – which can’t be ruled out – then treasuries could head back up again.

The Dollar is a Three-Time Loser

So despite the recent downside action – which was predictable based on end-of-year accounting factors – USTs still have a few things going for them. The Fed could yet intervene in a big way if treasuries fall too far, and investors could scurry back into USTs if the new year trading rally fades.

The U.S. dollar, on the other hand, looks like a three-time loser to me. Consider:

• If the Fed intervenes to support treasuries (in order to keep interest rates low), they will do so at the expense of the greenback. The Fed has to print dollars, or otherwise release dollars, in order to buy USTs in the open market.
• The powers that be (a.k.a. the Fed and Treasury) are implicitly supportive of strong treasuries (per the stimulative effect of lower interest rates) and a weak currency (also stimulative for exports).
• Whether the global economy rises or falls in 2009, the U.S. dollar no longer benefits from the foreign investor inflows that were once so strong.

In the “good old days,” when Americans were buying shiploads of “stuff” on credit from China – and paying with mountains of paper dollars – China happily recycled those dollars back into U.S. assets: equities, treasuries, mortgage backed securities, stakes in private equity firms, and so on. All this recycling was supportive of the greenback.

The same thing happened with the oil bought on credit from the middle east. The paper dollars sent to Saudi Arabia, Abu Dhabi and so on came right back home in the form of large purchase orders for dollar-denominated assets. This recycling factor kept the game going.

Now those U.S. dollar props are history. China’s risk appetite is shot, the oil exporters are no longer flush, and all parties are aware that the Fed wants a weakerdollar, not a stronger one, in order to stimulate U.S. exports and encourage local spending choices.

Multiple Scenarios

For these reasons, I am looking to build a sizable short U.S. dollar trade in the near future. I like the fact that a falling dollar is a probable outcome in multiple scenarios.

For instance, if the global economy bounces back in 2009: Emerging markets outperform, banks begin to lend, the Fed’s “quantitative easing” prescriptions kick in with a lag… and the dollar falls.

If the global economy gets worse: The new year equity rally fades, treasuries move higher, the Fed takes even more radical measures with its “quantitative easing” plan, the trillion-dollar stimulus ceiling is shattered… and the dollar still falls.

If the global economy gets much, much worse: Foreign holders of USTs get nervous and start dumping all remaining dollar-denominated assets… the Fed loads up on treasuries as a desperate buyer of last resort to keep interest rates low… and the dollar flat-out crashes.

You get the idea. There are certainly “dollar up” scenarios one could concoct, but in my view they are outnumbered by “dollar down” at least three to one.

In light of all this, I’ve been keeping an eye out for a tactical point of entry ever since the dollar’s sharp break a few weeks ago.

Based on the old trading truth that failed breakouts are some of the most convincing signals, we could see an excellent short-side entry point if – and it’s important to note the “if” here – the USD follows through on a reversal-type failure to the downside.

Source: Don’t Stay Short Treasuries – Short the Dollar Instead

Instead of establishing a new, specific primary interest rate, the central bank’s Federal Open Market Committee (FOMC) voted for a target range – 0.0% to 0.25% – a record low. Before yesterday’s cut, the Federal Funds target rate stood at 1.0%.

Instead of addressing the reason for its peculiar target range, the Federal Reserve opted for canned doomsday language that could have appeared verbatim in any of its previous rate cut announcements: It hasn’t been good. It doesn’t look good. And we’re trying to fix it.

Most cryptically, the FOMC said it “will employ all available tools” to promote economic growth and price stability. But those objectives could take some time to achieve.

“The committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time,” the Fed said in a statement.

U.S. stocks soared on the Fed announcement, with the Dow Jones Industrial Average gaining 359.61 points, an increase of 4.2%, to close at 8,924.14. The Standard & Poor’s 500 Index jumped 44.61 points, or 5.14%, to finish the day at 913.18. The tech-laden Nasdaq Composite Index jumped 5.41%.

Since September 2007, U.S. Federal Reserve policymakers have cut the benchmark Fed Funds target rate 10 times – taking it from its starting point at 5.25% to the current rate range, hoping it would encourage bank-to-bank lending, as well as bank-to-consumer lending.

“It’s a highly unorthodox and creative step,” Michael Woolfolk, senior currency strategist at the Bank of New York-Mellon Corp. (BK), told Reuters. “We think it’s the best possible move for the U.S. consumer and for the financial market.”

The rate cut announcement dropped onto a cushion of ugly headlines from earlier in the day:

• Consumer prices posted their biggest plunge in 76 years. The U.S. consumer price index (CPI) fell by a seasonally adjusted 1.7%, lead by a 17% decline in energy prices, the Labor Department reported. On a non-seasonally adjusted basis, the CPI fell by 1.9%, the biggest decline since 1932, three years into the Great Depression.
• Yields for 30-year Treasuries fell to an all-time low, Bloomberg News reported.
• Goldman Sachs Group Inc. (GS) reported a loss of $2.12 billion, or $4.97 a share, for its fiscal fourth quarter.
• New building permits and new housing starts hit a record low in November, as permits plummeted 15.6% to 616,000 units from 730,000 in October. Housing starts fell 18.9% to 625,000 from 771,000 in October, Reuters reported.

Joel Naroff, president and chief economist of Naroff Economic Advisors, doesn’t expect the rate cut to do much because banks simply don’t want to lend.

“There is little belief that will do anything as the issue is not the level of rates but the willingness to lend.  It may put a little more pressure on other central banks to ease, especially the Europeans,” Naroff wrote in a note to clients. “But other than that and the reduction in some variable-rate loans tied to the prime, the rate cut will not accomplish a whole lot.”

He added: “With the rate near zero, the Fed is basically out of bullets when it comes to the rate cut weapon so we will see what they say about using other mechanisms to add liquidity.”

Money Morning contributing editor Martin Hutchinson said in a recent column that the Fed’s rate cuts – combined with the government’s $700 billion bailout – will push so much money into the financial system that the final result will be widespread inflation – which is essentially an open invitation to profit from gold.

What Else Can the Fed Do?

With little to no room left to cut rates, Fed Chairman Ben S. Bernanke has signaled that he may employ unconventional ways to restore balance to the U.S. financial system.

The Fed extended the lives of recently initiated programs (lending facilities for investment firms, for instance) and is exploring additional moves (like Treasury purchases) aimed at reviving the credit markets.

Meanwhile, the U.S. Treasury Department is working on a plan to rejuvenate the housing market by slashing mortgage rates to 4.5% on new purchases. Experts say that, at some point, these stimuli must take hold, but that’s not necessarily true.

Many of Bernanke’s plans may be an afterthought on Jan. 20, when President-elect Barack Obama takes office with a different economic team and agenda.

New York Federal Reserve Bank President Timothy F. Geithner will be the new administration’s U.S. Treasury secretary, a role that will give Geithner the reins to what’s left of the Bush administration’s $700 billion bailout.

Former Treasury chief Lawrence Summers will head Obama’s National Economic Council. Analysts say this appointment puts Summers in line to succeed Ben S. Bernanke as chairman of the U.S. Federal Reserve in 2010.

New Mexico Gov. Bill Richardson will take over the Commerce Department, and Congressional Budget Office Director Peter Orszag will head the Office of Management and Budget.

Source: Fed Slashes Interest Rates to a 0.0% to 0.25% Target Range … But Now What?

We bought the Debt Strategies Fund (DSU), which held a basket of high-yield bonds and was paying a double-digit interest rate. From late 2002 to late 2003, trough to peak, the fund nearly doubled. In boring bonds!

We’re seeing a similar setup right now… So the question is, should we be buying high-yield bonds now?

Despite the big move back in 2003, bond funds aren’t supposed to double in a year. They’re not designed to…

The basics of a bond are usually something like this: You invest $1,000 in a bond paying 5% interest. You receive your 5% a year in interest. Then in five years’ time, you get your $1,000 back. No possibility of triple-digit returns there. But when we bought our high-yield bonds, some of those $1,000 bonds were selling for only $600. When the prices went up from $600 to $1,000, we made great money – plus the interest too!

Since late 2003, high-yield bonds haven’t done all that well. DSU is only up about 16% in four years or so. But now, DSU is paying more than 11% in interest. Is DSU a buy once again? Let’s see…

The last time we bought high-yield bonds, we were in the midst of the dot-com bust. Companies were going under. And investors were fleeing anything risky. Prices fell on high-yield bonds, as people sold. So bond yields shot up. That’s when we swooped in and bought.

We’re seeing a similar situation now… Investors have fled anything risky. And bond yields have shot up. Take a look:

This chart shows how much more interest you can earn from high-yield bonds than from U.S. Treasuries. You see, Treasuries are considered one of the safest investments out there… but you don’t get a big percentage yield. Right now, they’re paying less than 4%.

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When high-yield bonds are yielding the same as Treasuries, investors don’t have much incentive to take on the extra risk to get a slightly higher yield. And when times get turbulent, like now, investors flee high-yield bonds… which pushes the yield up. That gets me interested.

One thing is different this time though… Take a look at the next chart:

Historically, high yields on risky bonds have coincided with high default rates. But default rates on bonds have not risen yet.

So one of two things will happen… Either the default rate will soar, or – if default rates stay the same – high-yield bond prices will soar, and you’ll make a mint in shares like DSU, starting now.

If you’re really bold, and really optimistic about the economy, you could buy high-yield bonds now, and possibly make a lot of money.

But if you’re not so bold, like me, and you believe that things aren’t different this time – that default rates will climb in this recession as they have in the last two – then you’ll wait.

If you look closely at the chart, you’ll notice we’ve seen something similar to this two times before…

In 1989, default rates were low, but interest rates started to spike. Default rates started to rise a bit late, but they didn’t stop rising until they hit double digits. And in 1998, the same thing happened, and default rates again started rising and didn’t stop until they hit double digits.

I expect defaults will rise – which would hurt anyone invested in a bond fund now. But will defaults get to double-digits? I don’t know.

The double-digit yields on funds like DSU are incredibly enticing. But when it comes to high-yield bonds, I’m not willing to bite, yet.

Good investing,

Steve