Federal Reserve Bank Credit has increased by $1.2 trillion over the past twelve months. What has increased in the banking system? Excess reserves in the commercial banking system have increased by about $800 billion. Tracing this “stuff” a little further, in round figures, the currency in circulation outside of the banking system has increased about $100 billion over the past year, about $100 billion has gone to foreign central banks in liquidity swaps, so there is another $200 or so in funds that the Fed has pumped into the system that is somewhere in Treasury accounts. But who is counting?

I am still concerned with what the United States banking system is doing with the money that has been pumped into it. The answer is, very little!

Looking at the H.8 release put out by the Federal Reserve System we see that the assets of all commercial banks in the United States has increased by 9.7% from May 2008 to May 2009, an increases of $1.1 trillion.

And what accounts for this increase in bank assets? Well, the cash assets of the banking system has increased a whopping $731 billion or at a year-over-year rate of 236%. This is comparable to the year-over-year increase in excess reserves observed on the H.3 release of the Federal Reserve.

Given my post of last June 15, 2009, “What Aren’t Banks Telling Us?”, (http://seekingalpha.com/article/143276-what-aren-t-banks-telling-us) I was interested in looking a little deeper into this information to see how these excess reserves were distributed within the banking system. Roughly the division is this. The increase in cash assets at large commercial banks was $371billion, at small banks the increase was $143 billion, and at Foreign-related Institutions in the United States, $217 billion. The increase at the larger institutions, the large banks and the foreign-related institutions, was $588 billion.

The reason I am interested in looking into this distribution is the claim made in the above mentioned post that commercial banks had not been fully open with the public on the problems they were still facing. In that post I mentioned three areas of concern: the bad assets now on the books of the banks; the anticipated increase in the bad assets in the upcoming months; and finally, the needs of the banks to be able to fund themselves in the future in the face of liabilities that were maturing and would not be rolled over. The build up in cash assets, it was argued, was a precaution the banks were taking to handle the uncertainty they faced as either asset values fell or a run off of liabilities forced the banks to dispose of assets.

My interpretation of this distribution of cash assets in the banking system is that the larger depository institutions in the United States has stashed up almost $600 billion in preparation for an extremely bad scene. Why do I put this whole amount in this category? Because in the past the WHOLE banking system only kept about $2 billion in excess reserves and the banks we are talking about in this category are the most efficient and sophisticated banks in the world in terms of managing their cash reserves. So, excess reserves have gone from $2 billion in the WHOLE banking system to about $600 billion in the most sophisticated banks in the world!

Just to put this in perspective: $588 billion represents 7% of the total assets of the two groups that are counted in this category, large domestically chartered commercial banks and foreign-related institutions, both in the United States. The question is, can these banks really stand a 7% reduction in their balance sheets through charge offs or a run off of liabilities?

The situation is not so severe for the smaller banks in the report: cash assets totaled only 3.8 % of the total assets at these banks. Still, we are hearing more and more of the problems that the smaller banks are facing. For example, this week information was released that several smaller banks that had received TARP funds were not going to pay the dividend payments owed the government. The health of the smaller banks has been something that has been off the radar screen given all the press that has gone to those banks that are “too big to fail.” We are going to hear more from this sector over the next several months.

The next question has to do with bank lending: are banks doing any lending these days? Year-over-year, loans and leases at all commercial banks increased by a tepid $182 billion or at a 2.6% annual rate.2.6% annual rate. And, where were these increases located? Generally in home equity loans and other residential loans (primarily mortgages). These were pretty evenly spread throughout the banking system.

Bottom line, however, is that the banks aren’t lending! Especially in the areas of commercial and industrial loans and commercial mortgages. Does that tell you something?

What can we take away from this?

The scary conclusion is this: Almost all of the Reserve Bank credit that the Federal Reserve has pumped into the banking system has gone to provide liquidity to the banking system for when the banking system implodes.

Commercial banks are not lending. Yet the banks are sitting on $800 billion of excess reserves. It is almost incomprehensible to me that the commercial banking system is doing nothing with these reserves! Unless…

No one is talking, not from the banking system, not from the Federal Reserve. What else are we to think at this time if we are not given any other information. We just have to think the worst!

-John Mason

Disclosure: This article was taken from Mase: Economics and Finance with the permission of the original author.  All disclosure questions should be referred to the original author.

Unfortunately we are not yet in the clear.  The yield on the 10-Year Treasury Note increased 60 basis points during the one-month period from May 12 to June 12.  Oil prices rose 23% over the same period.  Keynesian economists argue that interest rates and oil prices are higher due to the expectations of economic recovery.  While the recovery may partially explain the increase in these prices, it doesn’t explain all of it.  The Treasury continues to auction billions of dollars, and auction demand has been less than great.  The rate on the 10-year recently skyrocketed to 4.00%.  Many economists are also predicting significant long-term inflation.  They point to the Federal Reserve’s policy of buying over $1.5 trillion of mortgage backed securities and US Treasuries, thus increasing the money supply.  They also fear monetization of the ever increasing national debt due to the exploding federal budget and the $787 billion stimulus package.

These fears are causing significant problems, especially in the housing market.  Without a recovery in the housing market, things aren’t likely to improve anytime soon.  Housing prices are the key to economic recovery.  Higher home prices will relieve the number of homeowners currently underwater on their mortgages, thus reducing the risk of them simply walking away.  Higher home prices also improve consumer sentiment, since more equity in their homes provides consumers with a sense of security.  This would result in both an increase in home equity loans and in personal spending.

But since mortgage rates are closely correlated with the 10-Year T-Note, the sudden jump in rates is threatening the economic recovery.  The 30-year fixed-rate mortgage rate increased 81 bps from 4.78% on April 30 to 5.59% on June 12.  Mortgage applications have been falling significantly, and it isn’t difficult to see why.  81bps adds $100 a month to a $200,000 mortgage.  $100 per month could be the difference between keeping your home and losing it to foreclosure.  If rates continue to climb, foreclosure activity will only get worse.

Higher rates will also force out first time homebuyers, causing downward pressure on home prices.  Though enticed with an $8,000 tax credit, higher monthly payments may cause them to rethink their decisions, and higher debt-to-income ratios may make it harder for them to get financing.  Combine this with continued housing starts, and you have a housing glut, thus driving down home prices further.

At this point, the Federal Reserve and federal government can’t do much to lower mortgage rates.  If the Fed purchases more securities, the inflation screams will only get louder.  If the federal government spends more money, more investors will fear the government’s ability to repay its debt.  The President talks about the importance of balancing the budget, so let’s see him put his money where his mouth is.

- Nick Klein

Disclosure: None.

Now, we are seeing the other side of the bailout business. In the AIG [AIG: 35.10, -0.56 (-1.57%)] case executives and others were angry because the government interfered with bonuses and other executive decisions. And, we have the government putting lids on executive pay. And, we have government wanting to rewrite mortgages, and cap interest rates on credit card debt, and so on and so on.

This is the other side of the coin.

And, now we learn from testimony given by Ken Lewis, the CEO of Bank of America [BAC: 16.09, +0.01 (+0.06%)], that Hank Paulson and Ben Bernanke put a “sock” in his mouth and strongly advised him that he say nothing to the shareholders or anybody else about the implications of the merger between Bank of America and Merrill Lynch.

Furthermore, we hear from New York’s Attorney General Cuomo that Paulson threatened to fire Lewis and remove the entire Board of Directors it Bank of America did not go through with the merger with Merrill Lynch! The reward—money from the Government to help BOA through the process.

The shareholders? Well, they lost on the value of their stock. And, they also will have higher taxes or an inflation tax that they will have to pay in the future.

In addition, why should any company, financial or non-financial even think of an acquisition in the future because the government may force the management to swallow hard, take on something that is not necessarily desirable for the company, and, of course, not inform investors as to the implications of the merger transaction?

And, why should the stockholders of any company approve any acquisition that is at all questionable? The precedent has been set that they might be approving something that will cost them considerable wealth as the stock of their company tanks, and they are given no information to give them any confidence that the transaction might be a worthy one.

What if the shareholders balk? What if they fail to approve such a merger? Will the government step in and force through the merger anyway?

Talk about a mess!

Two thoughts come to mind that I must express.

First, the combination of Paulson and Bernanke was a disaster as far as I can see. I have written about how Bernanke seemed to panic last fall and the result was the TARP. (See my post “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

Paulson didn’t do much better in his handling of the crisis and the creation and oversight of the TARP. I always thought that Paulson found the whole bailout idea not to his taste and had hoped that he would be able to get out of Washington before the collapse. Unfortunately for him—and for us—he didn’t make it. As a consequence here was a man doing something that he despised, and his heart, and mind, was really not in the effort. He has left us a very unhappy legacy!

When I reflect on the events of the last fall I keep coming up with the feeling that we would be hard pressed to have found two people less capable of handling the situation than the two that were then in charge. And, then there was the “Decider”, but he was AWOL!

The second thing has to do with the fact that the bankers, and other business leaders, are getting pelted with all the blame for the financial collapse and crisis that we have experienced. Thus we have the “bad guys” in our sights. Thus, they should pay.

But, what if the conditions that existed were created by the government and these bankers and other business leaders were just responding to the incentives initiated by the government? We had a credit bubble connected with the stock market in the 1990s. The credit bubble resulted in negative real rates of interest and consumers stopped saving. The saving rate fell from 7.7% of disposable income in 1992 to about 2.0% by the end of the decade. Then there was the huge deficits that resulted from the 2001 tax cuts and the “war on terror”. This was accompanied by negative real interest rates gain which resulted in the credit bubble in the 2000s and the housing boom. The consumer savings rate remained around two or below, even becoming negative for a short period of time.

The foreign exchange market in the 2000s indicated a fear of a renewal of inflation as the value of the dollar fell by more than 40% against major currencies. What were financial managers to do in such an environment? Generally, because spreads narrow in such times and arbitrage opportunities are based on smaller differences, you tend to leverage up and mismatch maturities. This response is a normal one to gain the needed returns on equity to keep money from leaving your fund or institution.

Is this greed? Yes, but it is also just the natural response of competitive people to the incentives that are created, in this case, by the government. The Bush 43 administration may have been composed of “Free Market Capitalists” but this “gang that couldn’t shoot straight” did more to harm capitalism than most other administrations in the history of the United States.

So, government gets it both ways. It can create the crisis. And, then it can impose itself on the economy to right the system after the crisis occurs. And, best of all, the blame can all be put on “greedy” bankers and the lack of regulation.

I am sure that before this is over we will hear many more horror stories.

- John Mason

Disclosure: This article was taken from Mase: Economics and Finance with the permission of the original author.  All disclosure questions should be refferred to the original author.

As it turns out while media talking heads were ranting about how the Fed was running their printing presses overtime to push up money supply the facts were very different. M1 has actually declined since the middle of December, 2008. During the same six month period M2 has only risen by a little less than 3%.

For some reason that I can’t explain most financial, economic and media experts don’t bother to read the Federal Reserve’s weekly money supply data before writing authoritative articles or spouting off on TV about money supply and its implications.

Of course, M3 followers argue that M1 and M2 are bad money supply indicators because they are too narrow and that only M3 should be used to measure the growth in money supply. Unfortunately, the Fed stopped publishing M3 a few years ago (because they said it was irrelevant) which started a club of M3 conspiracy theorists, i.e., people that believe the Fed stopped publishing M3 as part of a conspiracy to hide irresponsible monetary policy.

However, even without M3 being specifically published we know that broader measures of money supply, like M3, haven’t materially risen in 2009.

M3 followers can get a very rough idea of what M3 would have been, if it were published, by looking at the Federal Reserve quarterly Flow of Funds Accounts of the United States which was distributed yesterday. As it turns out, total net borrowing of the United States (private and public) dropped approximately $255 billion in the first quarter and other indicators of M3 fell or are about flat (on a net basis). The Flow of Funds Accounts data is inconsistent with a large rise in M3 (or a large rise in any money supply measure). By the way, this data supports Brad Setser’s theory that the fall in private borrowing is more than offsetting the rise in government borrowing and therefore, at least for the time being, financing the deficit isn’t a problem.

And, I have a suggestion for the M3 conspiracy theorists; get a life. Worrying about a Federal Reserve conspiracy isn’t worth your time and effort.

Set forth below is a chart that was compiled from weekly Federal Reserve data that illustrates money supply growth, seasonally adjusted, since the week ending December 15, 2008. The data suggests that the Fed is hardly “out of control” or a drunken sailor.

To those readers who want to flame me for not accusing Bernanke & Company of ruining the economy because of the growth in the Fed’s balance sheet, just hang in there. You will get your chance soon enough. Over the weekend I am going to write about the “irresponsible” expansion of the Federal Reserve balance sheet (or maybe why it wasn’t irresponsible at all).

-Mark Sunshine

Disclosure: This article is taken from the website Sunshine Notes with the permission of the original author. All questions regarding disclosure should be referred to the original author.

Since I wrote my article Paul Krugman wrote an article citing research done by Brad Setser that supports my thesis. Setser’s analysis predates my article and is really high quality work.

I am certain that Krugman didn’t have any idea what I wrote when he published his article but, just the same, Krugman’s subsequent writing is a helpful addendum to my “why not to worry about the debt tsunami” theme.

Basically, according to the analytical work done by Setser, the amount of public borrowing is being offset by a fall off in private borrowing. Less private borrowing is another way of saying that the savings rate has risen. Below is a graph from Setser’s article illustrating how the rise in government borrowing is more or less being offset by a drop in private borrowing.

Krugman concludes “We’re actually borrowing less from foreigners than we were before.”

Setser, on the other hand, worries that “…the challenge…will be to bring down the government’s borrowing as private borrowing resumes.”

-Mark Sunshine

Disclosure: This article is taken from the website Sunshine Notes with the permission of the original author. All questions regarding disclosure should be referred to the original author.

The second method is to inflate or reflate yourself out of the nominal debt burden you have created. The Federal Reserve is doing its best to create an inflationary environment so that the real value of the debt will be reduced and individuals, families, and businesses will feel comfortable enough to begin borrowing and spending once again.

The third way to reduce the burden of your debt is to repudiate the debt. That is, declare that you will not pay the debt and that those that issued the credit to you will have to take only a partial payment on the amount of funds that they advanced to you. The partial payment, of course, can be zero.

The latter two methods have an “honorable” history that goes back centuries. (Read almost anything by Niall Ferguson.) Usually, it is the government that can get away with either or both of these efforts, but in the 20th century, the private sector got much better in following the lead established by governments, especially repudiating the debt. Individuals, families, and businesses learned the ropes of debt repudiation and are now taking this knowledge to new extremes.

The case that is before everyone’s eyes these days is that of the automobile industry. Both General Motors and Chrysler argue that bondholders must take a huge cut in the amount of money they are owed by these companies so that the companies can survive and thousands and thousands of jobs can be saved. The bondholders, remarkably, have some reluctance to consent to this offer. As of this date, the aimed for restructuring of these two companies depend upon what is worked out between the companies and the bondholders.

Best guess is that the bondholders will lose. And, who will own the auto companies? Not the existing shareholders. The figure I have heard for General Motors is that existing shareholders will end up with about 1% of the ownership of the company after the restructuring takes place. And, not the existing bondholders. The biggest shareholders? The federal government and the labor unions.

The important thing, however, is that the debt problem being experienced by these automobile companies will be resolved. That is, the companies can move forward, leaner and meaner, without the terrible burden of having to honor the debts they had contracted for.

Furthermore, this is what has been proposed for the banking industry. In the plan to sell off bad assets, aren’t the banks being asked to repudiate a large portion of the debt they have on their balance sheets? The assets will be sold to investors and private equity firms to “manage” and this will get the banks out from under the burden of the “toxic assets” they have accumulated.

And, who will bear the risk of this buyout? The federal government, with the real possibility that it may, depending upon the way things work out, end up owning large portions of some of the larger banks. (An important critique of this program is presented by the economist Joseph Stiglitz in “Obama’s Ersatz Capitalism,” http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?scp=8&sq=jospeh%20stiglitz&st=cse.)

Might this plan work? Well, the people that the federal government wanted to get interested in the plan seemingly smell blood. We read this morning that Wilbur Ross and his firm’s parent company, Invesco, are leading a consortium that is going to bid on some of the assets in the government’s P-PIP. He is joining some other prominent money, like BlackRock [BLK: 225.66, -5.46 (-2.36%)], Pimco and Bank of New York Mellon, interested in getting involved in the program.

Do these people think that they might make some money out of this program? Do they believe that the risk-reward tradeoff is skewed in their direction? Damn betcha’.

Here is another case of “watch where the big money players put their money.” My guess for the future is that the evolving banking system is going to be somehow connected with the hedge funds and the private equity funds and will not have the same old “bank on the corner” feel to it that we experience now. And, somehow, this new banking system will be even harder to regulate than the current one. Otherwise, this money will not flow there. (Something to think about for the future.)

With these funds flowing into the P-PIP, one of the things the federal government is going to have to face is the huge profits that these companies will make out of the program. On the one hand, if P-PIP is successful in this way and these funds make huge profits, the banks will be freed up of their “toxic assets” and the tax payer will not be burdened with more taxes. On the other hand, the federal government will have to explain how it catered to all these “Wall Street Interests” and left the poor Main Streeter in his or her poverty.

The essence of the plan, getting back to the story here, is that the banks will have to take the “haircut”, the write down on the value of their assets. This is just another way of repudiating the debt, with the federal government standing behind the banks. Is it fair? Of course not!

A fund that made the wrong bet was Cerberus Capital Management. In a real sense, it hoped to do with Chrysler Corp. what Invesco, BlackRock, Pimco, and others, are hoping to do with the bank assets. It just got in too early when Chrysler was not in bad enough shape for the federal government to attach a “put” to the investment Cerberus made in the company. Too bad for Cerberus.

But, what about all the other debt out there? Mortgages on homes, debt on commercial real estate, consumer credit and credit cards, and small business loans? Why shouldn’t the people that accumulated all this debt get some relief as well? This is, of course, the big question and the big issue in terms of fairness. The basic answer to this is, as usual, size. The banks and the auto companies and others are big, their failures could case systemic problems for the system, and they have expensive lawyers and lobbyists working for them. Is it fair? Of course not!

The fundamental problem that is being faced around the world is a debt problem. There is just too much debt outstanding. And, actually, the amount of debt outstanding in the world is really not shrinking. Especially, as governments increase their debt to cover the debt that has been built up in the private sector. The debt problem is going to be with us for a while and will continue to get in the way, one way or another, of any kind of a robust recovery. How we get through it is going to set the stage for the type of world we have to deal with in the future.

- John Mason

Disclosure: This article was taken from Mase: Economics and Finance with the permission of the original author.  All disclosure questions should be refferred to the original author.

While interest rates are likely to rise for both long maturity Treasury notes and bonds and agency guaranteed residential mortgage debt, rising rates are not because of a lack of investment demand or failing confidence in the U.S. Government. Instead, as I have written for months, the all-in cost of capital for most domestic institutional investors is higher than the net yield on Treasury and agency guaranteed mortgage debt. The inability of domestic institutions to earn a profit at current interest rates isn’t the same thing as a lack of desire, capacity or confidence.

But of course yields are too low for private market investors to make money. After all, since December the Federal Reserve has been executing a program of open market purchases of Treasury and agency guaranteed mortgage debt designed to drive interest rates below market clearing yields. So, it shouldn’t be a surprise that among private investors there is an upward interest rate drift that can only be offset with more aggressive Federal Reserve intervention.

Private institutions can’t make money buying Treasury and agency guaranteed mortgage debt because the operating expenses of most institutions are very close to the investment yield on the Treasury and agency guaranteed mortgage debt. Unless the Federal Reserve is somehow able to magically force operating expenses of domestic institutions downward, market clearing yields are going to rise. At higher interest rates the private market won’t have any trouble absorbing the forward calendar of debt issuance.

To understand whether or not the volume of newly issued debt will swamp investor demand each type of debt needs to be broken down and analyzed individually and compared to sources of investment liquidity.

Residential Mortgage Debt

The amount of new mortgage debt isn’t a problem because basically there is no net new mortgage debt being created. There are two ways to create new mortgage debt; (i) refinance existing mortgage debt and (ii) finance home sales.

Refinancings, by definition, result in a repayment of old mortgage debt held by investors. For every dollar of refinanced mortgage debt that is issued there is a dollar of old mortgage debt that is retired. As a result, old mortgage debt investors receive cash that they recycle into newly created mortgage debt (or other investments like Treasury securities).

Mortgage debt created by home sales falls into two categories: new home sales and sales of existing homes.

The proceeds from purchase money mortgage debt created from sales of existing homes generally are used to pay off mortgage debt of the selling home owners. So, mortgage debt created through existing home sales is like refinancing debt, generally it doesn’t create net new mortgage debt.

If for some reason the debt tsunami worriers are agonizing about increased mortgage debt created from new home sales that should be the least of their concerns. If new home sales weren’t stuck in the mud there wouldn’t be a credit crisis or a deep recession which are the underlying causes of the debt tsunami. The United States should only have the problem that new home sales are so high it isn’t clear how they are going to be financed.

Treasury Debt

There is plenty of demand for long term Treasury notes and bonds, just not at current interest rates. The natural buyers for Treasury debt are domestic banks, thrifts and insurance companies. These institutions have more than $1 trillion of excess liquidity which continues to grow every day. The pool of domestic cash sitting on the side lines gets bigger every day because of a combination of increased U.S. savings and accommodative Federal Reserve policy.

 However, domestic financial institutions are sitting on the sidelines and not buying. The problem is that domestic financial institutions know that they can’t make money buying Treasury securities at current interest rates and no matter how much they would like to own long term Treasury notes and bonds they can’t invest.

When interest rates on long term Treasury debt rises above 5% domestic institutions will start to be large scale buyers. These institutions will start to make a reasonable profit without taking on unreasonable risk or leverage from purchasing long term Treasury notes and bonds.

Debt tsunami worriers need to pick something else to anguish about, at least for a while. Obviously, the current deficits can’t last forever but they aren’t in danger of swamping the economy for a long time. And, interest rates are inevitably going to rise but then again long term interest rates aren’t being set by the marketplace. Rising interest rates aren’t a source of worry but rather the beginning of the end of the great recession.

Please stay tuned for Part II of Don’t Worry About the Debt Tsunami coming shortly.

-Mark Sunshine

Disclosure: This article is taken from the website Sunshine Notes with the permission of the original author. All questions regarding disclosure should be referred to the original author.

How do you put a happy face on that? Easy, according to the folks at Casey Research. “However, the current correction is likely to prove beneficial longer-term with the pullback offering investors a chance to enter the market,” Moore said.

Meanwhile, “The market focus this week will be on the summit of BRIC countries tomorrow,” Barclay’s Capital analysts wrote, referring to Brazil, Russia, India and China by the common acronym.

The meeting in Russia, to which the US was pointedly not invited but did include the “re-elected” President of Iran, is expected to focus on the world monetary crisis and the dollar’s role in it.

Some think the countries may be preparing a call for a new international reserve currency, although whether they would have enough economic clout to push that remains to be seen.

Those interested in accumulating some of the precious metals version of “Natural Resources” might consider the gold and silver ETF [GLD: 112.94, +0.64 (+0.57%)] and [SLV: 18.22, -0.04 (-0.22%)] or the Market Vectors Gold Miners ETF [GDX: 50.82, -0.28 (-0.55%)].

Crude oil dipped on Monday and hit an intraday low of $69.58 a barrel on the Globex. On Tuesday as I write this it’s back to $71 a barrel.

One might have expected something of a rally off of the post-election turmoil in Iran, but that was downplayed in favor of concern over the supply glut.

“The first reason [for the oil retreat], of course, is the resurgent dollar,” said Phil Flynn, of Alaron Trading. “Then we got the Empire State manufacturing number that was much worse than expected, and that put pressure on oil.”

The Empire State index fell to negative 9.4 in June from negative 4.6 in May, indicating the downturn is widening to affect more firms, according to a report released yesterday by the New York Federal Reserve Bank.

[We are becoming more of a "Black Swan Investor" which is explained in our special report, "Fives Secrets to Creating Wealth in a Financial Crisis" which you can subscribe to by going to our home page and submitting your name and email in the sign-up section of the right-top quandrant of the home page.]

The bigger picture: “Stocks of oil are high all around the world — which suggests that on a supply/demand basis, oil prices should fall,” said James Williams, of WTRG Economics. “However, crude prices are supported because investors are using oil as a hedge against the dollar and inflation.”

This doesn’t mean we won’t see wild price swings in oil and the oil ETF [USO: 39.42, -0.24 (-0.61%)] in the weeks and months ahead. We might see a trading range develope between $60 on the downside and $75 on the topside.

“Commodities in general are seeing pressure as funds and individuals seem to feel that everything is overbought at this point,” said Zachary Oxman, managing director at TrendMax Futures. And, “Oil specifically seems strongly overbought.”

Commerzbank analysts concurred, writing that, “As the market was pricing in a rapid economic recovery, we think that the probability of a significant correction, taking place as early as in the coming weeks, is very high.”

But, of course, analysts have been saying that for weeks now, and crude has stubbornly resisted any big move to the downside.

Today brings the Energy Information Administration’s closely-watched stockpile report, and inventories are apt to decline again, says Linda Rafield, Platts senior oil analyst.

If you’re looking for a Natural Resources Exchange-Traded Fund that focuses mainly on energy, take a look at the iShares S&P North American Resources Fund [IGE: 33.80, -0.36 (-1.05%)].

IGE seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the S&P North American Natural Resources Sector Index.

Over 79% of the holdings are in the energy sector, and includes names like Apache [APA: 96.47, -0.60 (-0.62%)], Canadian Natural Resources [CNQ: 66.09, -0.93 (-1.39%)], Chevron [CVX: 76.77, -0.57 (-0.74%)], ConocoPhillips [COP: 52.08, -0.48 (-0.91%)] and Schlumberger [SLB: 63.34, -1.20 (-1.86%)].

As of the end of April the only precious metals company in the “top ten holdings” happened to be Barrick Gold [ABX: 43.98, -0.36 (-0.81%)].
Concerning ENERGY AND THE NATURAL RESOURCES MARKET
Last Saturday Frank Holmes of US Global Investors wrote the following review which is very insightful.

World oil reserves fell for the first time in ten years, according to BP’s annual Statistical Review of World Energy. Concurrently, the International Energy Agency (IEA) also stated that global energy investment is “plunging.” Projects worth $170 billion have been cancelled so far this year, equating to a loss of 2 million barrels per day (bpd) of oil production capacity. This is a concerning development given that the IEA forecasts global petroleum demand to rise from 85 million bpd in 2006 to 107 million bpd by 2015.
Strength

* The IEA revised its global oil demand forecast upward to 83.3 million bpd. Additionally, the Department of Energy’s EIA recently increased its global crude demand estimate.
* May imports of unwrought copper & copper products into China increased 6 percent sequentially and 113 percent from a year ago to 422,666 metric tons.
* The American Iron & Steel Institute said steel utilization rates increased for the week ended June 6. This is the sixth consecutive week, with the rate at 47.1 percent versus the prior week of 46.2 percent, but down from last year’s 91 percent.

Weakness

* BHP announced that it has settled benchmark metallurgical coal prices at prices around $128 per metric ton, which is approximately 55 percent lower than last year but in line with previous indications.
* Global stainless steel production declined more than a third to 4.8 million metric tons during the first quarter of 2009 according to the International Stainless Steel Forum.
* Gold Fields Minerals Services estimates that China’s consumption of copper should rise by 4.9 percent this year. However, even if that figure were to be 11.2 percent, the world would still face a surplus of copper in 2009.
* Canada’s principal energy producers have lowered their estimate of oil-sands output for the third time in a year, due to project delays and cancellations caused by falling crude prices and scarce available credit. Oil-sands production is now expected to come in at 1.9-2.2 million barrels per day in 2015.

Opportunity

* Iraq is looking to boost the output of its southern oil fields by as much as 500,000 barrels of oil per day by 2011. There are currently ongoing talks with major foreign companies to solicit help in reaching the goal.
* The Nigerian National Petroleum Corporation intends to increase Nigeria’s natural-gas production by 5 billion cubic feet per day or 147 percent by 2013. The country expects to spend $5 billion in the natural gas sector beginning this year in an effort to double its power-generation capacity to 6,000 mega watts.

Threat

* The IEA has calculated that investment in over 2 million barrels per day of oil and over 1 billion cubic feet of gas have been cancelled in the last six months. It is warning that sustained lower investment could lead to a spike in prices in only a couple years.

We are all hoping for a correction in Natural Resources prices this summer. Although I’m trying to be careful what I wish for, in the longer-term any corrections will most likely be looked at as favorable accumulation points.

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- Marc Courtenay

Disclosure: The author is long GLD and SLV. This article was taken with permission from Check the Markets. All other disclosure questions should be referred to the original author.

These figures come from the Federal Reserve statistical release H.3 “Aggregate Reserves of Depository Institutions and the Monetary Base.” I have used the “not seasonally adjusted” data.

This is unheard of! In May 2008, excess reserves were $2.0 billion and stood at 4.5% of the total reserves in the banking system. In May 2009, excess reserves totaled 93.7% of the total reserves in the banking system.

Unless someone can convince me otherwise there are, in my mind, only three reasons for this behavior. The first is the volume of bad assets currently on the balance sheets of banks that have not been recognized. The second is the volume of bad assets that banks anticipate will be forthcoming over the next year or so. The third has to do with how the banks have funded themselves in the past several years.

If these assumptions are correct, the recession cannot be called over yet and any economic recovery that might be forthcoming is going to be relatively tepid or postponed for some time. I obviously hope that I am wrong but something just does not “foot” with the data that I have reported above.

In the first category, current bad assets on the balance sheet, one would think that we know a fair amount about them. Their volume was sufficiently large so that the government put into place the TARP program and then followed that up with the idea of the P-PIP. Several banks feel sufficiently strong that they are returning their TARP money and it appears as if the P-PIP will never be actually implemented.

Financial markets have responded favorably to these events. Yet, we know that there still remain a large number of bad assets in the banking system. The current confidence has allowed some banks to return the TARP funds wanting to get the “Feds” out of their buildings and out of their compensation committees. In addition, with the relative calm in both financial and economic markets, confidence has risen within the banking system that maybe they can ride out the rest of the way to recovery, hoping that many of the remaining bad assets will turnaround or be refinanced or be worked with.

In my experience working in the banking sector, “hope seems to spring eternal” when it comes to believing that bad assets will eventually become good assets. The attitude is that “with time” the borrowers will come through.

But, what kind of confidence is it that sits on $844.1 billion in excess reserves, funds that are earning no return to the banks? Required reserves in the banking system in May only totaled $58.8 billion. What am I missing?

Let’s look at the second category, that about debt coming due or repricing in the future. We have seen more and more reports in recent weeks about the Option Mortgages that are coming due over the next 18 months or so; we read about all the commercial mortgage debt that is on the edge and this was accentuated this week with the bankruptcy filing of Six Flags; and we know that credit card delinquencies are still rising. What we don’t know is the extent of the fallout from the bankruptcies in the auto industry and how this will impact those industries and regions that have depended upon a healthy car business. In addition, personal bankruptcies and small business bankruptcies continue to rise and there is really no firm information about when the increase in these will moderate and what the effect on the banking system will be.

Finally, there is the problem of financing the banking system itself. I recommend that you take a look at the article by Gretchen Morgenson in the June 14 New York Times, “Debts Coming Due at Just the Wrong Time.” (http://www.nytimes.com/2009/06/14/business/14gret.html?ref=business.) Morgenson writes about the debt of the banking system and the need for bank balance sheets to shrink. The banking system, itself, needs to de-leverage and may have to do so unwillingly.

In this article, Morgenson refers to a study by Barclays Capital that discusses the amount of debt of financial companies coming due over the next year or two. The figures, roughly $172 billion of debt will mature in the rest of 2009 and $245 billion will mature in 2010. This means that financial institutions will have to refinance about $25 billion a month for the next 18 months or so. Part of the problem in refinancing this debt is that “many of the entities that bought this debt when it was issued aren’t around any more.” Furthermore, in general, “few buyers of short-term bank debt are around now.”

Raising equity capital is fine, but, over then next few years, the banks may have a larger hole to finance in terms of the debt that it must try to roll over. This, of course, will put more pressure on the policy makers. The policy makers have gone out on a limb in attempting to protect the need to write down bad assets. The policy makers have provided capital for some of the banks that were in the worst financial shape. The next issue has to do with the need for the purchase of bank liabilities. This may be a very tough balancing act to complete successfully.

But, maybe the government has already provided the funds to meet these emergencies. Maybe that is why banks are holding such large amounts of excess reserves. They know that over the next 18 months that they are going to have a severe funding problem. Excess reserves are the perfect answer to paying off the debt as it runs off, leaving the banks with a lot of funds that still can buy them time to “work out” the bad assets that remain on their balance sheets.

- John Mason

Disclosure: This article was taken from Mase: Economics and Finance with the permission of the original author.  All disclosure questions should be refferred to the original author.

The Fed has been engaged in an effort to purchase longer term United States Treasury issues on a continuous basis as well as Federal Agency issues and mortgage-backed securities. It has made purchases in sizable amounts weekly. Now, the Fed seems to be losing its grip on yields in the long term end of the market.

The rationale given for this slippage? The record amounts of debt the United States government has to sell.

It is true that there are and will continue to be record amounts of debt issued by the United States government coming to the market now and for as far as we can see in the future. The supply issue may have some effect in the short run, but let me provide another possibility for the rise in rates in the longer term end of the yield curve.

The argument about whether or not the central bank can significantly impact yields in the longer term end of the yield curve has been going on for almost the entire length of my professional career. First, people think that the central bank can, and should, conduct open market operations so as to lower long term interest rates in order to spur on the economy. Then, research is produced that indicates that the Fed cannot achieve a significant reduction in long term yields through open market operations. A little later, some others think that it would be a good idea for the central bank to conduct open market operations to reduce long term interest rates. This is followed by another round of research indicating that the central bank cannot achieve this goal. Now, we are back at the point where policy makers believe that the Fed should attempt to keep long term interest rates low.

My reading of history is that the Federal Reserve cannot control, for any length of time, yields on long-term Treasury issues!

My reading of history also causes me to believe that the supply of Treasury securities cannot impact, for any length of time, the yields on long-term Treasury issues!

I am one that believes that long-term Treasury yields are determined by the appropriate expected real rate of interest and the expected rate of inflation. Since the expected real rate of interest does not change over short periods of time, the general movement in longer-terms interest rates will be determined by changes in expected inflation. And, expected inflation is dependent upon what the financial markets believe the Federal Reserve will be doing with respect to the monetization of the federal debt.

This, of course, has been a big fear in the financial markets. With all of the projected government debt coming down the road, many market participants believe that the Federal Reserve will have no choice but to monetize large portions of this debt. As more and more of the debt is monetized the probability that inflation will rise increases. And, this expectation gets built into long term interest rates.

If this is true, then the central bank faces a real dilemma. When the Federal Reserve attempts to keep long term interest rates low, it can cause a rise in inflationary expectations and this will create upward pressure on long term interest rates. If the Fed monetizes more of the debt to keep interest rates at the lower level, inflationary expectations will become even greater, putting even more upward pressure on long term interest rates. And, as long as the central bank continues to keep these long term yields below where the market wants them, the more damaging will be the consequences in the future.

In all my experience, I have not seen the Federal Reserve succeed in keeping long term interest rates below where the market wants them to be. I don’t expect them to succeed in their present efforts.

And, what about inflationary expectations? I believe that we can provide evidence from other markets that confirm this recent sensitivity to the increasing pressure on the monetary authorities to monetize the government debt. I am not concerned with the absolute levels of expected inflation, just the direction in which the spread has moved.

The spread between the 10-year government bond yield and the rate on 10-year inflation indexed government bonds is often used as an indicator of movements in inflationary expectations. The spread remained relatively constant from January 2009 through March. However, in April the spread has increased by 2 ½ times the January figure. This spread now is at a level we have not seen since early October 2008, right after the fall crisis hit. Market participants seem to be increasingly worried about what the Fed is going to have to do.

Furthermore, every time we see this spread increasing we tend to see a decline in the value of the United States dollar against the Euro and against other major currencies. Relative currency valuations are highly dependent upon changes in what central banks are expected to do because their actions can affect relative rates of inflation. If investors believe that the central bank in your country is going to monetize its government’s debt more rapidly than that of another country, the value of your currency will decline relative to that of the other country.

In this respect, the value of the United States dollar has declined over the past two days and tends to drop every time there is a rise in yields on longer term Treasury bonds. This would indicate that some of the same things affecting the yields on long term bonds are also affecting the value of the currency.

A final piece of evidence in support of this idea is that the market also responded to the minutes released yesterday by the Federal Reserve’s Open Market Committee. In those minutes the Fed stated that “the economic outlook has improved modestly since the March meeting…” It also noted that household spending “has shown signs of stabilizing while businesses have cut inventories, investments and staffing” implying that if consumer spending does stabilize or even increase, businesses will have to restock their shelves in order to support this spending which would be positive for economic recovery. Both of these statements foresee a stronger economy in the future, reinforcing the earlier fears of the market.

Long term Treasury yields were low because there was a flight to quality and because inflationary expectations were low. Unless there is another major shock to the system, I believe that the flight to quality is over and is in the process of being reversed. In addition, I believe that the Fed will continue to monetize the debt in increasing amounts for the Fed also emphasized in the minutes released yesterday that they will “stay the course” in the fight against an economic collapse. For both of these reasons, I feel that pressure will continue for long term Treasury yields to rise and for the value of the dollar to fall.

- John Mason

Disclosure: This article was taken from Mase: Economics and Finance with the permission of the original author.  All disclosure questions should be refferred to the original author.