When Stocks Start Down, So Goes the Pound!

The Federal Reserve Bank has increased its balance sheet by about $2 trillion since October 2008. Meanwhile, the Dow Jones Industrial Average bottomed in March 2009 and has risen 110 percent based on Thursday’s close.

But turning to the real economy we find that that $2 trillion has produced a 9 percent decline in total outstanding commercial and industrial loans. Granted, growth has improved, but it is still below October 2008 levels.

This is not exactly achieving the Fed’s goal of pushing credit into the real economy.

But it is very powerful evidence of three important items:

• The Fed’s mechanism of bringing lenders and borrowers together is broken.
• Credit is flowing to the ‘financial economy’ but not the ‘real economy.’
• The lack of real economy stimulation helps explain why U.S. corporations are sitting on their cash; a cool $2 trillion according to some estimates.

What Our $6 TRILLION in
Additional Debt Bought

In terms of fiscal policy, the U.S. government has pumped $4 trillion in new government debt into the economy while the Fed was pumping in its $2 trillion. All this fiscal spending must have provided some stimulus to the real economy, even though the monetary plumbing is clogged — right?

Wrong.

Here are some results; the list is limited to your imagination:

• 200,000 business bankruptcies
• 5 million individual bankruptcies (highest ever for a 14 consecutive quarter period)
• The lowest rate of new business formation since the 1990s
• 5 million fewer employed and another 8 million who left the workforce (this is likely a conservative estimate)

Not to mention one of the most tepid post-recession recoveries on record.

I think you can see the problem here. Indeed all the money and credit has been stimulative, but it has not gone into productive real assets! Instead it has led to a boom in the financial economy. So what are the chances Boom’s ugly stepchild — Bust — will emerges from the closet once again?

I think the chances are very good.

Some say the real economy has hit bottom. But those who say that forget just because we haven’t seen a positive feedback loop to the real economy from the financial economy, doesn’t mean we won’t see a negative one if collateral values (stock market) tumble.

But really …

Can This Game Go on Indefinitely?
What Is to Stop It?

Well, I would suggest two plausible reasons why it ends:

First, there is the political pressure …

Everyday Americans know something is seriously wrong. They may not know all the economics behind it, then again who does. But they know their great-great grandchildren will be working down this debt if something isn’t done very soon. And they’ve had it up to here with politicians burning through their hard-earned tax dollars as if it were their own.

Second, professional investors will stop believing …

The herds of smart guys who run most of the money in the world invest on a “don’t fight the central banks” mentality. It has served them very well. But at some point even they may recoil from this mantra as they seriously evaluate:

• The ever growing disconnect between financial asset prices and real underlying productive assets propping them up. And …
• The fact the world has changed in a very big way since the crisis four years ago; in a way suggesting the entire system of globalization and the growth models that have sustained it, may be reversing.

What This Means
for Currencies

It would mean those currencies that have been highly correlated with global stock markets would likely get hammered first.

One currency that has shown such a high, positive correlation to stocks is the British pound. In the chart below I have compared the price of the British pound to the S&P 500 Futures Index (red line). It is crystal clear how closely they move along the same path.

Click the chart for a larger view.

To sum it all up, when our government’s meddling no longer works and stocks start down, going short the British pound might be an excellent intermediate-term trading opportunity.

Now of course, timing is everything when it comes to investing in currencies. The market can be extremely volatile. So if you are looking for clear, concise instructions on when to get into a position and when to get out for the biggest possible payoff, you should give my World Currency Trader service a risk-free try.

Best wishes,

Jack