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Thunder Road Report 13 8th July 2009

Thunder Road Report 13 8th July 2009

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8th July 2009

This issue:
Stop the inflation or deflation debate - we have both until inflation prevails (“Badlands - getting close to a dollar crisis” Part 2)

Stop the inflation or deflation debate – we have both until inflation prevails
The great debate between the inflationists and the deflationists rages on. Most commentators fall firmly into one camp or another. In fact, we are experiencing both inflation and deflation simultaneously due to the extreme distortions created by the reckless policies of central bankers and politicians in the UK and US. Ultimately, one of these forces will overwhelm the other and it will almost certainly be inflation in response to a currency crisis. It should be fairly obvious now that if the UK and US economies were left to their own devices (without the heavy-handed meddling by the gentlemen referred to above), economic gravity would dictate that they would both experience a prolonged period of deflation and depression. Kondratieff cycles since the Industrial Revolution

Source: Ian Gordon/Long Wave Group

Here is the link to a full-screen version (see page 2 of the presentation) of this excellent chart:
Contact/additions to distribution:

http://www.longwavegroup.com/flash_pres.html

Paul Mylchreest paul@thunderroadreport.com

Stated simply, we are in the “Kondratieff Winter” part of the long wave economic Kondratieff cycle which has been repeating itself at least since the Industrial Revolution - and some would suggest even back to the agrarian economy. As I showed in the Gold War report, the best illustration of these long wave cycles is the chart created by Ian Gordon of the Long Wave Group above. A Kondtratieff Winter typically lasts at least 10-15 years as the Japanese experience of the last two decades has shown. While extremely painful, it is necessary to repair the fabric of the economy, i.e. purge the excessive debt built up during the Spring, Summer and (especially) the Autumn phases of the Kondratieff cycle, remove excess capacity and recapitalize the banking sector, etc. This takes time, but once completed, the economy is ready to begin a new long wave cycle. If we wanted to avoid the pain of the K-Winter, the behaviour of politicians, central bankers, the banking system and consumers would have to change – but every generation forgets the lessons of history, even when the evidence to the contrary is staring them in the face – like it was with our dear leader. “And we will never return to the old boom and bust”
Gordon Brown budget statement 21 March 2007 after the onset of the sub-prime crisis

If you understand the different phases of the K-cycle, you also know which asset classes tend to outperform in the different phases. So in a typical cycle, for example, you only buy gold in the inflationary Summer phase and the deflationary Winter phase (I am not a “perma gold bug”), the stock market and real estate typically do best in the recovery Spring phase and the debt-driven bull markets of the Autumn, while Treasury bonds do best (unless the value of the currency is destroyed) in the deflationary Winter phase when everything else, apart from gold and cash, collapses. The downward “gravitational pull” of the K-Winter cannot be underestimated – look at what Japan tried – almost zero interest rates for years, massive deficit spending and public works, quantitative easing - and its economy still didn’t escape deflation and economic stagnation. While all these policy actions failed in Japan, they are being repeated in the UK and US. The risk we face is that Darling, King, Bernanke and Geithner are guilty of Einstein’s definition of insanity: “Doing the same thing over and over again and expecting different results” The only intellectual justification they have for their policies is that Bernanke, the student of the Great Depression and the Japanese deflation, has argued that Japan responded too slowly and that its initial actions were not sufficiently aggressive. The reality is that we are in uncharted territory – taking the economic equivalent of the trip up the Nung River with Captain Willard in Apocalypse Now. Back in 2007, I was arguing that we had been in a “distorted K-(Kondratieff) Autumn” since the beginning of the decade. What I tried to explain was that the US economy would have slipped into a purging deflationary recession in the wake of the dot.com bust in 2000 if it wasn’t for Greenspan’s massive reflationary action at the time, e.g. bringing interest rates down to 1% and leaving them at that level for a year which ignited the real estate bubble. Debt/GDP in the US economy back then was about 270%, in line with the peak reached in the Great Depression. But it wasn’t just real estate. While Marc Faber didn’t call it a “distorted K-Autumn”, he grasped the unusual situation that prevailed before the current crisis: “…the feature most common to the previous investment booms was that a bull market in one asset class was accompanied by a bear market in another asset class. Currently, looking at the five important asset classes – real estate, equities, bonds, commodities, and art (including collectibles) – I am not aware of any asset class that has declined in value since 2002.” Thanks to Greenspan, what could have been a difficult, but milder, adjustment process was averted, but at what eventual cost? Now US debt/GDP is above 350% and attempting to reflate the current bust is requiring measures that would have been considered beyond reckless not long ago. We are now in a “distorted K-Winter” where the lessons of previous economic cycles are important, but events might not play out in the usual fashion.

© Thunder Road Report - 8 July 2009

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That said, given “economic gravity” and historic experience, it is understandable why so many experienced market participants are in the deflation camp. For example, Absolute Return Partners, a London-based (by the river in Richmond, lucky them) hedge fund, writes an interesting monthly newsletter. The July issue is titled “Make Sure You Get This One Right”. After quoting Robert Prechter “You can’t beat deflation in a credit-based system”, ARP argues: “We are faced with another one of those ‘make or break’ decisions which will effectively determine returns over the next many years. The question is a very simple one: Are we facing a deflationary spiral or will monetary and fiscal stimulus ultimately create (hyper) inflation?” The ARP authors come down firmly on the deflationary side (inflation is not a concern to them for “several years”) and their main arguments are: - The massive liquidity created by central banks is being hoarded by the banking sector, rather than finding its way into the economy - Agree; - The output gap, i.e. the low level of capacity utilization across the economies - Agree (n.b. in Ben Bernanke’s “make believe” world, this is about the only thing he looks at with regard to inflation risk); and - A counter-intuitive argument that rising commodity prices (due to demand growth in emerging economies, rather than the developed world) could be deflationary, rather than inflationary - Disagree. Regarding the third point, ARP specifically argues that rising prices for price inelastic commodities like “basic necessities such as heating oil, petrol, food, etc.” leads to less demand for discretionary goods and acts more like a tax hike. Demand for other goods is therefore weak contributing to deflation. I agree that the rising price of basic necessities acts like a tax hike because there is limited ability to reduce energy and food costs. But it’s precisely because of this, and the heavy weighting of these items in consumer expenditure, that higher food and energy prices flow so readily through to inflation. Tricksters like Bernanke and other central bankers might want to focus on their ludicrous concept of “core” inflation, excluding food and energy prices, but this misses the true inflation faced by households. While there may be less discretionary spend for other goods, higher energy prices, also flow through the entire cost structure of all domestically produced and imported goods. In some areas, they are likely to be passed on to consumers while in others, the hit might be taken by the manufacturing and distribution sectors in their margins. I really don’t mean to have a go at ARP and it is worth noting that they are in very good company. The successful London fund manager, Hugh Hendry, was spreading the deflationary gospel only last week on CNBC. Hendry’s current view fascinates me, since it was an article written by him several years ago which motivated me to read about John Law and what he did to the French economy in 1720. Hendry is probably wise enough, however, to realize that he will need to turn from deflationist to inflationist on a sixpence at the appropriate time and, given his record, he might nail it. Further in ARP’s defence, the fund managers also recognize that the coming years will be vastly different from the last 20-30 in the investment world and they correctly, in my view, see pronounced volatility in the years ahead (This is the “global end of normal”, baby). While there is evidence of deflation all around us – year-on-year the stock market is down, house prices are down, industrial commodity prices are down and some non-food retailers are cutting prices, the overall story is more complex. In the UK, Halifax (now part of the Lloyds Banking Group) not only tracks house prices, but also the overall cost of owning and running a house. The comparison between April 2009 and April 2008 is shown below:

© Thunder Road Report - 8 July 2009

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Annual cost of owning and running a home in the UK (£) April 2008 Maintenance & repair of dwelling Water supply, etc Electricity, gas, other fuels Household appliances Tools for house & garden Goods & services for routine household maintenance Telephone account Toiletries, cleaning products, etc Household insurances Council tax, domestic rates Total costs excluding mortgage interest payments Mortgage interest payments Total cost of owning and running a home
Source: Halifax, ONS

April 2009 630 458 1,409 205 172 350 308 154 360 1,261 5,308 1,990 7,298

Change % +5% +5% +13% +5% +2% +7% +1% +3% +1% +3% +5.8% -47% -17%

600 438 1,249 195 169 327 305 150 357 1,228 5,018 3,748 8,766

The overall cost of owning and running the average house in Britain has declined by 17%, but the only category to have shown a fall is the cost of mortgage payments. While this is the single largest expense, the cost of everything else has risen by 5.8%! That’s more than double the Bank of England’s 2.0% inflation target and this is in the middle of the biggest recession since the 1930s. The overall CPI inflation measure was still 2.2% in the UK in May 2009, albeit down from the 5.2% peak last September. Within that 2.2%, food prices were up a massive 8.4% in May from a year ago. So much for no inflation!. The latest CPI reading in the US for May 2009 showed deflation, with prices down 1.0% year-on-year, but that’s only because the US rigs the data. However, John Williams of shadowstats.com calculates that the rate of inflation was +2.0% year (similar to the less manipulated UK data) versus a year ago adjusting for the distortions to the CPI calculation (i.e. substitution, dodgy seasonal adjustments, geometric weighting and my personal favourite, hedonic regression) introduced during the Clinton years. Using even older, more realistic methodologies, the CPI is higher still. The rigging goes back to LBJ. We should also acknowledge that while many commodity prices have crashed from their year-ago levels, they have been very strong of late. So the oil price is 72% above its low, copper 76%, nickel 81%, cotton 54%, soybeans 48% and wheat 11%, respectively. Hopefully the above demonstrates that the inflation or deflation story is much more complex than being a simple question of black or white. Of course, there’s an output gap in many parts of the economy and consumer expenditure remains very subdued, but it’s just not that simple. While Bernanke is a student of the Great Depression and Japanese deflation, I’ve studied the Kondratieff Cycle, Austrian economics and the collapse of Bretton Woods. In normal circumstances, I would also be singing the gospel of deflation from the rooftops, but this is not going to be “normal”. Aside from the combination of rapid population growth/low food stocks with the coming peak oil era, the starting point for the unprecedented policy actions being taken by the US and UK is completely different from those of the US in 1933, when FDR instigated his “New Deal”, and the early 1990s, when Japan stepped up its policies to combat deflation. The US in 1933 and Japan in 1990 were, respectively, the biggest creditor nations in the world at the time. The US in 2008 was the world’s biggest debtor and technically insolvent and the UK similarly was similarly heavily indebted.

© Thunder Road Report - 8 July 2009

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We are currently experiencing both deflation and inflation, but the latter will eventually prevail, in my opinion. Furthermore, it will almost certainly be in response to a currency event, i.e. big falls in the values of the US dollar and Sterling, rather than an economic event, e.g. the closing of the output gap. We will do well to remember von Mises’ (Austrian school): “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Here is a comment from the Central Bank of Iceland from page 29 of its Monetary Bulletin from November 2008 which sounds the same warning: “Debt that grows in excess of income cannot be sustainable. Sooner or later, such behaviour must cease, if not due to the borrower’s prudence, then due to the lender’s actions (creditor backlash – see below, Paul). This applies to public sector finances as well.” We all remember that it was the excessive debt of Iceland’s major commercial banks (and their inability to refinance their short-term debt) which led to the collapse of the krona and the whole economy in the wake of the Lehman failure last September. A quick aside - as I keep saying in Thunder Roads, surrealism is the order of the day and the first line of the first page of the Central Bank of Iceland’s November 2008 Monetary Bulletin - the first post-collapse issue - was: “The objective of the Central Bank of Iceland’s monetary policy is to contribute to general economic wellbeing in Iceland. The Central Bank does so by promoting price stability, which is its main objective.” Back to the collapse in the value of the Icelandic krona. From a high of 58.50 ISK/US$ in November 2007 during the early stages of the crisis, the krona collapsed by just over 60% versus the US dollar, reaching a low of ISK147.98 in early December 2008. Look what happened to Icelandic inflation which peaked at more than 18% around the turn of the year: Iceland - CPI (%) year on year

Source: Central Bank of Iceland

Here are some relevant comments from that November 2008 Monetary Bulletin: “The outlook for inflation is extremely uncertain and will be determined by the exchange rate to a large extent. The credibility of the Bank’s inflation target has been badly damaged…”

© Thunder Road Report - 8 July 2009

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“Retailer’s mark-ups have probably been depleted to a large extent, prompting them to pass cost increases through to retail prices in spite of a sharp contraction in demand.” (currency crises make a mockery of the output gap, Paul) “…implies that real wages will fall considerably and that real disposable income will contract by as much as 25% between year end 2007 and year end 2009.” Last week I was talking about how we are getting close to a dollar crisis and how it is likely to be caused by creditor backlash – just as it was in 1968 when Bretton Woods collapsed. Back then the creditor backlash was led by France with Germany and Switzerland in supporting roles. A quick aside - not surprisingly the British government sold 43% (869 tonnes) of OUR gold reserves in the doomed bid to save the dollar, while the French ended up 2,770 tonnes of gold to the good. Anyhow, the most interesting thing from last week was showing how similar the comments made by French President Charles de Gaulle and his Prime Minister, Georges Pompidou, were in the run up to the dollar crisis in 1968 compared with the comments coming out of the Chinese Central Bank this year. Both camps emphasized their dissatisfaction with the world’s reserve currency being the product of one nation at a time when that nation had ballooning deficits. Besides China, Russia has obviously been very critical of the dollar and they were joined last week by India. Bloomberg reported that Suresh Tendulkar, Chairman of the Economic Advisory Council for Manmohan Singh, India’s Prime Minister, is urging the government to diversify its US$265bn of foreign exchange reservers. Tendulkar was quoted as saying: “The major part of Indian reserves are in dollars, that is something that’s a problem for us.” It was interesting because Tendulkar characterized the problem of managing the nation’s reserves as a “prisoner’s dilemma” ands said: “That’s why I’m telling them to do this (diversify)” As we know from the game theory of the “prisoner’s dilemma”, most people opt to betray and, with China and Russia already diversifying their reserves, what else can India do but follow suit? It also struck me as interesting that these comments from India come so soon after the inaugural meeting of the BRIC nations on 16 June 2009 in the Russian city of Yekaterinburg. If you remember, the meeting ended with a declaration calling for a multi-polar world order” and a “more diversified international monetary system”. Meeting those objectives requires a deliberate strategy to undermine the dominant geo-political position and the value of the US dollar, which increasingly go hand-in-hand. On this subject, Chinese companies in selected cities, Shanghai, Shenzhen, Guangzhou, Zouhai and Dongguan, have just been granted permission from the central bank to settle international trade in Yuan for the first time on a pilot basis. This got Jim Sinclair of jsminset.com going: “Wake up you slumbering Western sheeple! China is not just talking as your media would have you believe. As head of the BRICs they are ACTING!” Shrewd analyst, Frank Veneroso, picked up this bit of information: I am told that recently UBS held a get-together for central banks and sovereign wealth funds around the world. They asked them about their current asset preferences. The asset most preferred was gold; the asset least preferred was U. S. government bonds... The bankruptcy of the state of California is getting some coverage in the mainstream financial media, but not what it deserves in my opinion. To me, much of what’s happening in California is a microcosm for what is happening to the US as a whole – it is just more advanced. State Governor, Arnold Schwarzenegger, sent revised a budget to the state legislature to close the US$24bn budget deficit back in May. Despite having more than a month before the new financial year began on 1 July 2009, politicians couldn’t agree on a new budget and the state is now issuing IOUs (paying a 3.75% yield) to its creditors. To me this is indicative of an inability and lack of political will in taking pre-emptive

© Thunder Road Report - 8 July 2009

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action to cut spending before the state’s finances hit the wall. The same thing will happen at the federal level in due course. During a press conference Schwarzenegger recalled “Back in 1967 Governor Ronald Reagan said, ‘The time has come to match outgo(ings) with income, not the other way around’. Well, you know something? It’s really interesting that now, 42 years later, Sacramento still hasn’t learned how to do that. For decades Sacramento has pushed its financial problems down the road, kicking that can down the alley.” If there was ever a message for Geithner and Bernanke! Continuing with the theme, Schwarzenegger went on to discuss the massive unfunded liabilities faced by California over and above its current budget shortfall: “And this is not just about this particular budget or about education and health care and those kinds of programs. We have a huge problem in this state with unfunded liabilities. For decades now the legislators have promised people things we can’t deliver. I mean, look at pensions. We have to go and have pension reform or the state of California has to literally pay in a minimum of $12 to $14 billion a year in order to meet our goal in the pensions, which is $600 billion. I mean, where does that money come from? Right now we have only 300 billion but we need 600 billion. Somehow we have to pay for those things. Or for the unfunded liabilities in health care for our state employees, $118 billion unfunded. No one knows how to get that money. Where do we get this money from? So it’s easy for the politicians to keep promising things but they can’t deliver it. They live way, way beyond their means and that’s what we have to change.” I couldn’t agree more with Mr Schwarzenegger, but he was elected Governor in 2003 and neither he nor the state legislature have managed to resolve this issue during the intervening years. At federal government level, the unfunded liabilities are approximately US$63 trn (technical insolvency) and it is heading down the same path as California – the only difference being that the former can print money and inflate its way out of the situation – which is exactly what I expect it to do. The federal government is refusing to bail out California and if it remains true to its word, we have to assume that eventually a compromise is reached with the latter making major spending cuts. Obviously this will have a knock-on impact on California’s economy. In the meantime, I’m interested to see what happens to happens with California’s IOUs. When it last issued IOUs in 1992, they were honoured by the banks. This time, banks like Citibank, Wells Fargo and Bank of America have also agreed to accept them, but Bank of America announced that this was only until 10 July 2009. The other banks followed suit. I’m interested to see if the value of the IOUs begins to attract a discount if a new budget isn’t agreed quickly. That could have a knock-on effect on the dollar. Meanwhile, the “pre-tipping point” slow motion destruction of the dollar continues. Outside of the BRICS, it looks like South Korea is preparing to buy gold according to the East Asia Daily on 4 July 2009. “The Bank of Korea has not purchased gold for 11 years but is expected to go on a gold buying spree, as the world’s central banks have bought the commodity since the global economic erupted in September last year. A Bank of Korea official said yesterday, “The bank has begun to set up a plan to manage foreign exchange reserves for next year. It has also closely watched central banks in other nations and trends in the global gold market. The bank has said nothing officially, simply saying, “We have made no decision on the purchase of gold and cannot say if we have considered it.” It will finalize by November its plan to manage foreign exchange reserves for 2010, but experts forecast that the bank will have no choice but to buy gold soon…Chang Min, the head of the Korea Institute of Finance’s macroeconomic research division who worked at the central bank until late last year, said, “The central bank has long considered several alternatives such as buying gold to diversify its foreign exchange reserve portfolio, which is heavily focused on dollars. It needs to secure more gold to diversify its investment.”

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I like this comment which came into GATA Chairman, Bill Murphy, although I’ll need to check how true the last bit about not being able to get Swiss safety deposit boxes for love nor money: “A friend of mine is head of wealth management for California for a major foreign bank (Big job). He has his clients not in ETF’s and not in PM (precious metals) stocks but in 5-15% positions in buillion, mainly gold but definitely silver exposure as well. I introduced him a few years ago to Bert Blumert (RIP) at Camino Coin in San Mateo, CA. When he leaves Camino Coin his Mercedes is weighed way down in the trunk and with the headlights angled up! He takes delivery on behalf of some of his clients and stores it with ‘the bank’. You would not believe how financially strong these clients are. It takes $5,000,000 in liquidity for his shop to take you on and he has several 9 figure clients. The accumulation is quiet and steady. The nugget is this. My friend said that right now in Switzerland you cannot get a safe deposit box in a bank. They have no vacant boxes because they are all leased and full of gold and this has happened over the past 12 months.” Ross Hansen, the founder and President of the Northwest Territorial Mint was very interesting on gold buying demographics on the Financial Sense news hour at the weekend: “The demographics have shifted tremendously. We are seeing a lot of more institutional type investors, people coming making large purchases on behalf of organisations because, like everyone else, they see the writing on the wall when it comes to the currencies. Also, we’re seeing a lot more females buying metal. Where it used to be just 10% females, it’s now probably 40% because women are recognising that the most conservative investment they can make…is precious metals.” The Royal Canadian mint, which last month admitted to an unaccounted for C$15.3m shortfall between the amount of gold and precious metals in its vault compared with that needed to reconcile with its financial statements, issued the findings of a review by Deloitte Touche. According to the findings “the unaccounted for difference in gold does not appear to relate to an accounting error in the reconciliation process, an accounting error in the physical stock count schedules, or an accounting error in the recordkeeping of transactions during the year”. So nobody seems to have done anything wrong, but the gold has gone. There was no news last week regarding the rumoured auditing of the inventory at the major bullion banks. Besides inflation or deflation, the other great debate is green shoots or yellow weeds? I’m still bearish as I’ve outlined in previous Thunder Roads. The green shoot camp took a hit last Thursday with the worse than expected US non-farms payrolls data. The headline number showed an increase in US unemployment in June of 467,000 compared with the consensus estimate of 363,000. Courtesy of the superb forensic work by John Williams, I thought it was worth looking at the recent underlying trend. For the increasing number of people who have become clued in and understand that the data is manipulated, the headline figure is just the starting point for working out what is really going on. John Williams of shadowstats.com estimates that the true rise in unemployment in June was more like 700,000 as he explained: “Net of the Concurrent Seasonal Factor Bias and net of distortions built into the reporting by the BirthDeath Model, the June jobs loss likely exceeded 700,000.” For those not familiar Williams’ work, the “Concurrent Seasonal Factor Bias” (CSFB) arises from the lack of correlation between the annual change in both the seasonally adjusted and unadjusted series for any given month. This would be okay if positive and negative differences offset each other over time, but they don’t. Ten out of the last twelve months have been favourable to the unemployment numbers to the tune of a net 1.21m jobs, i.e. about 100k per month. As I said last week, more people are now aware of the Birth-Death model manipulation. This is the number of supposed jobs created or lost through the start-up or close of small businesses that come under the radar of the Bureau of Labor Statistics. Obviously in recessions, you would expect the number to be a net loss of jobs, but it is almost always an increase – 185k estimated by the BLS in June 2009.

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The table below shows the level of job losses in the US during April to June 2009 adjusting for the CSFB and Birth-Death model. US - estimated underlying change in unemployement in 2009 (000s jobs) March Headline reported CSFB Birth/death model Underlying change
Source: BLS, shadowstats.com

April 504 (48) 226 682

May 322 89 220 631

June 467 46 185 698

652 87 114 853

There is no clear trend at this point. The May headline figure had got the bulls very excited, but on an underlying basis was probably little better than April. In June, we dipped down again to marginally below the April level. That said, these months were considerably better than the 900k-1.0m of underlying job losses in November 2008 and February of this year. With the unemployment picture looking so bleak and house prices still declining, I’m not surprised that rumours were swirling round the markets yesterday of another US stimulus plan. Bloomberg reported yesterday: “The U.S. should consider drafting a second stimulus package focusing on infrastructure projects because the $787 billion approved in February was ‘a bit too small’, said Laura Tyson, an outside adviser to President Barack Obama. The current plan “will have a positive effect, but the real economy is a sicker patient,” Tyson said in a speech in Singapore today. It didn’t take too much analysis to see that all those supposed “shovel ready” infrastructure projects to revive the US economy in the first stimulus plan amounted to less than 10% of the US$787bn. A new programme will require even more money which the Federal government doesn’t have, which means either more debt or more money printing, which means more pressure on the US Treasury bond market and the US dollar, which will lead to a dollar crisis and inflation. In the meantime, central banks continue to try increasingly desperate reflation measures. An interesting story which popped up last week was the one which suggested that Sweden’s central bank has lost the plot by making deposit rates negative. I wonder whether Bernanke and Darling et al are reckless enough to try the same thing? On 2 July 2009, the Riksbank cut its forecast for 2009 GDP growth in Sweden from -4.5% to -5.4%. In light of this, it not only cut the main repo rate (at which it lends to the banking system) to 0.25% but forecast that it would remain at this level for a whole year. ”The weak development of the economy requires a somewhat more expansionary monetary policy. The Executive Board of the Riksbank has therefore decided to cut the repo rate by 0.25 of a percentage point to 0.25 per cent. The repo rate is expected to remain at this low level over the coming year.” But further down the press release in the last paragraph was the following: ”The deposit rate is at the same time cut to -0.25 per cent” Are Swedish savers are now being charged 0.25% p.a. just to keep their savings in the bank? This is madness and encourages Swedish savers to take money out of the banks, which could threaten the already shaky viability of the banks. Maybe it's just for banks not individuals? We’ll have to watch how this develops. There was something else which infuriated me about the Riksbank announcement. While cutting the 2009 GDP growth forecast big time, acknowledging that the repo rate will have to remain negligible for a whole year and that ”the situation on the labour market is continuing to deteriorate rapidly” (and is not expected to recover until 2011 by the way), it raised the forecast for 2011 GDP growth from +1.3% to +1.4% although the 2011 GDP forecast remains unchanged at 3.1%. Ha ha ha ha, how ridiculous is that, I nearly fell off my chair! Message to nice Swedish people – the government and the banks are going to rip you

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off for being sensible enough to have savings, but keep the faith because the Riksbank’s super accurate forecasting model says that the recovery next year will be a all of 0.1% stronger than it previously thought. Switching tack, governments have always acknowledged their intervention in the short end of the government bond markets and the currency markets. We have established beyond any doubt that the US (illegally) and, to a lesser extent, the UK, have been intervening in the gold and silver markets for just over a decade. Since the current crisis unfolded, they have intervened in the long end of government bond markets, mortgage backed securities, CDS, CDOs and commercial paper markets. Despite all manner of suspicious moves in the stock market – numerous rallies in the last few minutes of the US trading day (often driven by sudden surges in volume in the S&P future) and the ”managed crashes” post Bear Stearns and Lehman Brothers and more discussion of the roles of the President’s Working Group on Financial Markets (Plunge Protection Team) and the Counter Party Risk Management Group, many market participants don’t want to believe the dirty secret. Despite this, the debate won’t go away and even hit mainstream financial media a few days back on Bloomberg TV (here). I didn’t see it live but my thanks to Zero Hedge and Sense on Cents who were all over it. The interview is with Joe Saluzzi of Themis Trading. He is an agency dealer in equities, i.e. he executes the trades for his clients in the market, so he is very close to the trading action (just like you, Pete Murden of RP). If you missed it, this is what Saluzzi had to say: ”The volume that you see during the day right now, some days as high as US$12bn across all three exchanges is fictitious, it’s not real okay. I’m going to say that 60-70% of this volume you see come across, it’s volume, but it’s not real, but it’s done by what they call high frequency traders. These are machines – the biggest machine out there wins the game nowadays (and we know who that is) – and these people deal in sub-seconds, 50 milliseconds is a huge amount of time. Anything over that and you’re a dinosaur in the business. So what they do all day long is bascially buy and sell and they try to collect liquidity from the exchanges, who are basically in partnership with them. They trade for no apparent fundamental reason and this is my problem and being that we are in a bullish tape right now, they’re all just buying....During the day when a programme gets shot through and, by the way, a billion shares a week going through a certain broker on the exchange with principally related programme trades is a way to get the market to go in your direction. And what happens is, since we’re all electronically linked, the algorithms the other institutions use chase the programmes and artifically inflate the prices”. The Bloomberg anchor asked whether the rally we’ve seen is due to this type of trading and is not real. Saluzzi replied: ”It cuts both ways, that’s right. Since we’re in a bull tape everybody’s jumping on board, but here’s the trick. They can run for the trap door tomorrow and if everybody becomes a seller, it’ll all just go the other way. They don’t care about the price anymore.” The point here is that the manipulators (government acting through its banking agents) do care which general direction markets go in. For now, they want the stock market up (to signal recovery – although it’s getting difficult as people lose faith), the Treasury bond market stable and, as always, the gold price capped. The other Bloomberg anchor then asked Saluzzi that if the market is manipulated, whether there will be regulatory reforms? Given the complete lack of action by the CFTC in Comex gold and silver, his reply was realistic: ”I don’t think they will reform it, I think the SEC has already kind of said ’hey you’re a big boy, you’re playing in this game, deal with it’ and they have noted that in certain comments...I have a feeling one day the door is going to close, everybody will be running for the exits, there’s going to be a major move in the markets and everybody’s going to be wondering what happened? What about that crazy guy on Bloomberg television that day and he was talking about these high frequency guys? There’s a problem structurally in the equity market that nobody wants to talk about (some of us will, Paul). There is intervention, there’s manipulation going on. No one has exact proof of what’s going on (we do in gold and silver and VERY

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RECENTLY in equities if you see what I mean!), but it’s out there and the real liquidity has been gone for a while when we got whacked down 40% last year. It never came back, people don’t understand, the liquidity’s not back.” A debate I did see live on market manipulation was on Financial Entertainment TV just over a week ago (here). This involved a four way discussion between the attractive Australian anchor who’s name I don’t know, Rick Santelli down on the floor of the Chicago Board of Trade (the only credible CNBC reporter in my view), Larry Levin who trades the S&P future down on the CME floor (and has done for 20 years) and Steve Liesman, CNBC’s economics commentator. Nathan Martin of Nathan’s Economic Edge characterized it superbly as “Three Who Get It & One Idiot” and as he pointed out: “As I’ve been saying, this rally has been trumped up from start to finish. Every now and then the truth leaks out of CNBC, usually when Rick Santelli is around.” Here is what Larry Levin had to say: “This market continues to be propped up by the government intervention and manipulation and as that continues to happen I think this market can go higher. The government’s been doing a good job of keeping it that way, no matter what the underlying current is unfortunately.” The anchor then asked what will happen in the second half of the year and whether reality would hit home. Levin replied: “If the government can keep putting all these IOUs out and printing money I guess not. I would have said the first six months many professional traders would have told you the same thing. This market should not continue to move the way it has, move up four months in a row basically. But that’s what it’s done and you’re going to have to pin it right on Obama and his staff as basically trying to prop this market up on a daily basis and they’re doing a good job.” That was all too much for Liesman who had to jump in at that point and cut Levin off. For a brief moment, before the camera switches to Liesman, Levin’s face shows utter disgust. Later Levin chips in again: “These markets are not free markets. This whole year has been absolutely ridiculous. I don’t know when it’s going to stop but, as far as I’m concerned, this continues to drive the market higher.” Santelli obviously had to be careful (his job might depend on it) but weighed in saying he agreed with most of what Levin had to say. The authorities are trying everything they can to buy time. The situation is akin to spinning more and more plates until the tipping point (literally) is reached.

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Author: I started work the month before the stock market crash in 1987. I’ve worked mainly as an analyst covering the Metals & Mining, Oil & Gas and Chemicals industries for a number of brokers and banks including S.G. Warburg (now UBS), Credit Lyonnais, JP Morgan Chase, Schroders (became Citibank) and, latterly, at the soon to be mighty Redburn Partners.

Disclaimer: The views expressed in this report are my own and are for information only. It is not intended as an offer, invitation, or solicitation to buy or sell any of the securities or assets described herein. I do not accept any liability whatsoever for any direct or consequential loss arising from the use of this document or its contents. Please consult a qualified financial advisor before making investments. The information in this report is believed to be reliable , but I do not make any representations as to its accuracy or completeness. I may have long or short positions in companies mentioned in this report.

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