Stock markets are on fire this week! Investors are delirious over Wednesday’s news of ‘coordinated central bank action to boost liquidity in the financial system’.
But the thing is, liquidity isn’t the real problem. The big problem the world is facing is to do with solvency. And as far as I’m concerned, you can’t solve a solvency issue with liquidity.
But what does that really mean? Today I’d like to take a look. And after that, I’ll show you what I think you need to do to best deal with what’s coming.
Here’s what’s been going on this week…
The US Federal Reserve is no longer content spraying dollars all over the US landscape. Now it’s taken to spraying liquidity over the rest of the globe, too. The fact is, the Fed is fed up waiting for European politicians and the ECB to pull their collective finger out and find a solution to the debt-hole in which many EU member states find themselves.
The Fed’s solution? To provide dollars to the global banks in a quantity and at a price never seen before.
This is what the US does best. Shock and awe.
But what does it mean for you and me as investors?
Something nasty’s lurking beneath
We’re clearly getting close to the wire now. The Fed has seen something it’s scared about. Why else would it take such strong and immediate action?
I can only guess that some Euro banks are on the brink. Having been left holding rotting sovereign debt, they’re out on a limb. The European authorities aren’t doing enough to help. The Germans are doggedly sticking to their sound money principles – and that’s hampering the ECB.
And because nobody knows which banks are teetering on the edge, it means that banks are less willing to lend to each other. Banks rely on a constant stream of money flows to stay in business. Like a spinning plate, once it slows beyond a certain speed, it comes crashing to the floor.
And seeing as the US has long since dumped any notion of sound money, they’re now promising to keep the plates spinning. They’re providing freshly minted dollars to quench the banks’ thirst for liquidity.
And that’s the number one aim for the Fed: to keep the banks going.
Why is the Fed being so generous?
So the Fed has selflessly given of herself to sort out some liquidity for those slovenly Europeans. But why would she do that?
As the announcement of a fresh round of dollar stimulus hit the markets, the dollar plunged like a stone. That’s because some of these dollars are likely to end up being exchanged into other currencies. And anyway, more dollars sloshing around the system dilutes their value.
And here’s the crux of the matter: a lower dollar suits the Fed.
As the dollar falls, financial markets tend to rise. And boy did the markets rise in the aftermath of this announcement. The Dow had its best day in over two years rising over 4% – and some European markets did even better. And the Fed just loves a frothy market. It’s good for the banks and generates a feel good factor.
A lower dollar also helps US exports and hampers imports. It’s good for her economy.
As such, the Fed’s ‘generosity’ should be viewed in the light of a global currency war. Paper currencies are being trashed. And that’s set to continue for years.
But what about solvency?
So the stimulus is in. The plates keep on spinning. Great.
Of course, stimulus after stimulus can keep the plates spinning some more. But what stimulus can’t do is tackle the root problem. And the root problem is that the value of many of Europe’s sovereign bonds is getting mauled.
And seeing as it’s the banks and financial institutions that hold this stuff, in due course they’re going to get mauled too. In fact behind the scenes, I suspect you’ll find that there have been one or two banks that have been driven to the brink of insolvency and that’s what prompted the Fed to take action.
The only way to solve the solvency issue is to get the over-indebted nation states back onto a sound footing. That’ll bring back some value to their sovereign bonds and bring bond yields back down to somewhere near normality.
But there’s a problem. Nobody knows how to do that. What do you do? Lower government spending, or raise taxes? Neither of those is likely to create growth in the economy.
We’ve been trying to find a solution for years… and nothing seems to work.
So for now it’ll be more of the same. Keep the plates spinning and hope for the best.
Hedge your bets on inflation and deflation
Bank implosions are deeply deflationary events. Money (and savings) are literally destroyed. It means that less money is floating around the system. And given the leverage operated by most banks, the deflation can occur in double-quick time.
But if the Fed can keep dowsing the globe with liquidity, then that’s going to be inflationary. Creating more money generally is.
So we have a dilemma. Inflation and deflation call for different types of investment. Inflation tends to favour shares, while deflation leads us down the bonds route.
My answer is to keep hold of both. We don’t know how this will turn out. I wouldn’t commit to one strategy over the other.
But what I will say is this: Get hold of some gold.
Bank blow-ups, inflation, deflation or stagnation. None of these things are good for any sort of financial investment.
Gold, on the other hand sits kind of alongside the ‘normal’ financial universe. As I’ve said before, you can’t diversify away financial risk with gold. If the markets slump, it’ll probably take the gold price with it.
But in the unlikely event of a ‘financial system reset’ then you’ll want physical possession of gold and other tangible assets.
The Fed can keep the plates spinning. But remember, spin them too hard and things may go wrong too. Hyperinflation isn’t out of the question – and that’s another outcome that favours gold.
For more on how to invest in physical gold click here.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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