The Liquidity Trap Unfolds

The Dow’s over 12,000 again as I write this. Bad news seems to have a very temporary effect on this juggernaut that’s been largely aided and abetted by the Federal Reserve’s cheap money policy. How much longer can THEY keep it going? Well, in theory they can keep it up forever. The Fed’s goal is to continue to flood the market with liquidity in the hopes that it will finally move on its own. Reminds me of an old sports car I used to drive. After it sat for a while, it wouldn’t start. I would pump and pump the accelerator, turn over the ignition for what seemed hours and slowly it would sputter, then sputter some more and finally it would start up and belch some blue smoke. All the while in the back of my mind I was playing out a scenario where I might have to quickly reach under the seat for my fire extinguisher if the carbs caught on fire.

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Essentially that is the same trap that is unfolding in the markets today. The Fed is priming the pump in the hopes that the economy revives. The problem is that I have not heard of a back up plan in the event this liquidity driven event becomes a paper asset bubble, which is what is occurring right now. Don’t get me wrong, I would much rather see the market go higher than lower. But, when it moves higher on weak fundamentals and the forced creation of money, I have trouble sleeping at night.

It’s not a question of “here’s the bad news” that no one’s talking about. Heck, there’s no need to concoct any type of story. It’s all right there in front of you. Take one statistic about the housing market, which is not in any way close to recovering – in fact it’s still declining overall. From the period between 1963 and 2005 New Home Sales averaged around one new home sold for every 400 Americans. After the most recently released New Home Sales data, that number is now one new home sold for every 1,250 Americans (these numbers are annualized). That my friends is not a misprint. It shows in black and white the seriousness of the problem we are facing.

Oil’s Not Well

Unless you own oil stocks of course. Here we are back at two and half year highs for crude oil. It just printed $106 per barrel. Can you say $5 gas at the pump soon? Probably won’t happen – I’ll tell you why. If the price of gasoline and oil continue to rise, the same thing that happened last time will happen again. People will just slow down their consumption and the economy will follow in lockstep. Now, don’t for a minute think that oil prices are going up because of demand. Oil demand is out there for sure, but prices are set at the margin and by traders on the commodities exchanges. They really could not care less what you or I am paying at the pump. Their interest is in paying their own bill and they do that by making profits from trading the trend in oil.

What is happening in the Middle-East/North Africa is like an early Christmas present for these guys. And, what is happening in Japan is proving to be a boon for all energy commodity prices except for uranium. Just to highlight the absurdity in the oil market for a minute: Japan is a 100% oil importer. Its economy has just stopped dead in its tracks. Yet, the price of oil is up more than 15% since the quake – no prices are not related to supply and demand in this market, not over the short-term.

This also leads back to the first part of my commentary on the Fed and pump priming. The rise in oil prices almost mirrors the fall in the US Dollar. Oil is priced in dollars so this makes sense. The real observation is that the US Dollar is falling and that is leading to higher prices for all commodities – it’s called inflation. So, while you may be sitting back and thinking the Fed is doing the right thing by flooding the market with dollars…unless there is a plan for sucking those greenbacks out of the system…you are going to feel the pain of cheap money and it ain’t gonna be cheap!

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