SmartChart_November 6 2010

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1 James M Edwards 602.441.4303

SmartChart/Cycle Update Monday 11-08-2010

Bias:

DI: BUY per the INTRADAY guidelines

Key numbers:

Intraday Break Point: Buy above 1188 sell below 1188, special attention to 1178

Cycle: current reading is 938 Cycle Stage: buy, could be entering a period of 1200 bids POMO: November 1, 4 and 8

Pre-market:

Premarket talks about those items that directly affect what we will be doing each day in the market.

Premarket has NOTHING to do with macro economics.

http://www.youtube.com/watch?v=Hcali31939o&feature=player_embedded

The video above is the ONLY mention of small business I can find in a politician. We know for a FACT

that 9 out of 10 jobs come from small business. Why has the Federal Reserve REFUSED to fund small

business? Why is credit out of reach? You want jobs? You fund small business again.

I first want to make it clear that we are entering a period of FALSE DEMAND. THAT is what QE2 is. It is

DEMAND that is not generated by an economy that is operating to produce demand. It is DEMAND,

none the less and you dont fight 1.1 trillion dollars. When it ends (see John Mauldins letter under

comments) there will be severe consequences when the program ends.

With that said the short side we were preparing for is off the table. We will concentrate on the Long

side. The macro strategy will be to maintain a long above the 1st

std deviation. The intraday trades will

be contained to being above DI and ANT.

Those of you that were around Friday you saw the importance of 1212.50 and 1222.50 with regard to

the ten point run.

Maintain a vigilance at 1117 you know why.

We get one shot at 1.1 trillion. I doubt the FED will be able to do it a third time as the republicans are

already screaming audit the fed again. The FED has only delayed the decline. Without labor increases

this is all a temporary reprieve. I say that again because one signal to get besides the program ending

will be the break of 1st

std deviation. There is ample statistical evidence to support that.

With that said we should look for a slight pullback to the 1212-1210 level. If that breaks we could easily

see panic to 1180. I will stress again that QE money should produce a buy the dip mentality. Dont try
http://www.youtube.com/watch?v=Hcali31939o&feature=player_embeddedhttp://www.youtube.com/watch?v=Hcali31939o&feature=player_embeddedhttp://www.youtube.com/watch?v=Hcali31939o&feature=player_embedded


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to short this. Let the market go short, YOU go for the long side. Why? The long side will run faster than

the short side.

In conclusion the money is FAKE but it cannot be ignored. You cannot stand and say the economy is

bad, even with evidence

http://www.philadelphiafed.org/research-and-data/real-time-center/business-conditions-index/

and demand to be right when the FED is going to pump 1.1 trillion into the market in the false belief that

keeping the RICH RICH will trickle down to the rest of us in the form of jobs. IT wont work and Im not

the only educated individual to present evidence that it wont. However, until the fake money stops the

market will respond in kind.

I spent 11 years learning and perfecting how a NORMAL market works with normal demand (cash from

buyers, real buyers) which translates to volume. Now Ive had to spend a year learning how the market

works under the direct control of the Federal Reserve. Frankly its Pavlovs dog. They run money and

the market eats, take the money away and the market sells into strength. Know when the food arrivesand you have a pretty good idea of when the dogs eat ( and the dogs are the Dow ).

As long as we understand what is going on it is all just a process to be exploited and used to our benefit.

We used to see 1 billion a day as normal volume. Now we have seen 1/10th

that volume and recently

one half billion the last couple of days but make no mistake about this: THE RETAIL SIDE IS DEAD, THE

FED CONTROLS THIS MARKET.

I will be talking a lot about the economy, small business, money flows, Federal Reserve, bond yields, IMF

(which just reorganized to bring India and China into the top 10 quota), etc. It is my SINCERE HOPE that

once the new political process in Washington begins that we see small business turn the corner. At that

point I want to see bond yields go up and the trillions of dollars in bonds released to support this market

with REAL demand, and real growth.

This bottoming process is now the longest in history. I had hoped I could out live it but now with QE2 it

is time to make some serious money. Perhaps in the end that is Bernankes hope.

Those of you that have participated in the room have seen some pretty incredible metrics/tools develop

as a direct result of the inquiry as to how the FED/Treasury manage the market when normal demand

is absent. Friday saw support at 1212.50 and a market top at a projected 1222.50. We saw price stop at

the Doji High to the tick. We saw the Open and PT1 work to the tick. We saw the channel s influence

and DI influence and we saw ANT work to the tick. This is a combination of floor activity and the FED. Itis a bit complex but by god and country weve got it down pat. Ive a lot of time with the students, now

go for the brass ring and stop doubting yourselves, believe the chart. You will never be 100% right,

never but that is the way life itself works.

james
http://www.philadelphiafed.org/research-and-data/real-time-center/business-conditions-index/http://www.philadelphiafed.org/research-and-data/real-time-center/business-conditions-index/http://www.philadelphiafed.org/research-and-data/real-time-center/business-conditions-index/


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Market Outlook:

Trading Outlook is concerned with intermediate and long term macro economics. It has a bearing on

INTERMEDIATE and LONG TERM thinking.

Comments:

Comments are concerned with news links, commentary from other sources and any other news worthy

item(s). It deals with what can change the macro economic landscape; with what is brewing under the

surface.

There are going to be severe consequences for Bernankes QE2 actions. John

Mauldin this week sums those up pretty well but they dont cover any ground I

have screamed about earlier. Ive warned about velocity of money, Ive warned

about GDP, Ive warned about employment and Ive warned about liquidity traps.


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In fact I was preparing for severe shorts just before Bernanke saw the SAME data

and prepared QE2. I warned of a severe and devastating decline and that is

exactly what we would have seen had it not been for QE2 and a fake 1.1 trillion in

spending (which by the way, is about the amount of money weve lost due to

unemployment). Ive warned that Bernanke has done what he can do and that

now is the time for FISCAL reform. Bernanke is at his LIMIT and unless we get solid

FISCAL reform the ONLY THING BERNANKE has done is extend the time for PAIN.

Although we are temporarily safe once the program is over you will see that the

economics are NO BETTER but the markets will be at nose bleed levels. It will be

the short of the century IF the FISCAL order has not been changed.

Thoughts on Liquidity Traps

by John Mauldin

November 5, 2010

In this issue:A Few Thoughts on the EmploymentNumbersBernanke Leaps into a Liquidity TrapHow to Spot a Liquidity TrapToy BlocksLondon, The End Game, and Changes

I am in London finishing my new book, The End Game, which will be out after thefirst of the year, as soon as Wiley can make it happen. Working with my co-author, Jonathan Tepper, we are making good progress. We intend to quit (abook like this is never finished) tomorrow afternoon.

I am going to beg off from personally writing a letter this week, but will give yousomething even better. Dr. Lacy Hunt offers us a few cogent thoughts on theunemployment numbers. The headline establishment survey came in muchbetter than expected, but the household survey was much weaker. In addition,Dr. John Hussman wrote a piece last week that I thought was one of his best, onliquidity traps and quantitative easing, and that's included here, too. We areembarking on a course through uncharted waters. No one (including the Fed) has


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any idea what the unintended consequences will be.

I remarked a few weeks ago that the Fed is throwing an inflation party and notsure whether anyone will come. Last night at dinner, Albert Edwards of SocieteGenerale noted that not only do they not know whether anyone will come, they

do not know what they will do if they do come, how much they will drink, or whenthey will leave.

My quick takeaway is the $600 billion is not all that much, and the buying isconcentrated in the middle of the curve, where it is likely to do the least in termsof lowering rates (they are already low!), so also likely to do the least damage.Mohammed El-Erian thinks that if nothing happens the Fed will be forced tocontinue, which is a dangerous thing. I wonder whether they might just shrugtheir shoulders and say, "We tried, and now it is up to the fiscal side of theequation." We shall see. It will be important to listen to the speeches of the Fedgovernors to get some idea.

Before we jump in, let me give you a few thoughts I am picking up in Europe. Theyield spreads on Irish and Spanish bonds are blowing out even as we speak, aswell as those on the rest of the periphery. While all eyes are on the Fed, the realaction may be in Europe. We will visit that thought in the near future. Now, first toLacy.

A Few Thoughts on the Employment Numbers

By Dr. Lacy Hunt, Hoisington Investment Mgt. Co.

The October employment situation was dramatically weaker than the headline159k increase in the payroll employment measure. The broader householdemployment fell 330k. The only reason that the unemployment rate held steady isthat 254k dropped out of the labor force. The civilian labor force participation ratefell to a new low of 64.5%, indicating that people do not believe that jobs areavailable, but this serves to hold the unemployment rate down. In addition, theemployment-to-population ratio fell to 58.3%, the lowest level in nearly 30 years.

While not actually knowing what happened to the net job change in the non-surveyed small business sector, the Labor Department assumed that 61k jobswere created in that sector. This assumption is not supported by such important

private surveys as those from the National Federation of Independent Businessor by ADP. Just a month ago the Labor Department had to revise downward thejob totals due to a serious overcount of their statistical artifact known as theBirth/Death Model.


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The most distressing aspect of this report is that the US economy lost another124K full-time jobs, thus bringing the five-month loss to 1.1 million in this mostcritical of all employment categories. In an even more significant sign, the level

of full-time employment in October was at the same level that was reachedoriginally in December 1999, almost 11 years ago (see attached chart). Aneconomy cannot generate income growth by continuing to substitute part-timework for full-time employment. This loss of full-time jobs goes a long way toexplain why real personal income less transfer payments has been unchangedsince May.

The weakness in real income is probably lost in an environment in which the Fedis touting the gain in stock prices and consumer wealth resulting from the latestquantitative easing (QE), but QE has unintended negative consequences for realhousehold income. Due to higher prices of energy and food commodities, QE

may result in less funds for discretionary spending for consumers whoseincomes are stagnant. Also, with five-year yields falling below 1%, rates on CDsand other types of short-term bank deposits will decline, also cutting intohousehold income. At the end of the day these effects will be more powerful thanany stock-price boost in consumer spending, which, as always, will be very smalland slow to materialize.

To have a broad-based recovery, the manufacturing sector must participate.


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Contrary to the ISM survey, manufacturing jobs fell 7k, the third consecutivedrop, resulting in a net loss over the past three months of 35k.

In summary, the latest economic developments indicate a slight worsening ofunderlying fundamental conditions.

Bernanke Leaps into a Liquidity Trap

John P. Hussman, Ph.D.www.hussmanfunds.com

"There is the possibility ... that after the rate of interest has fallen to a certainlevel, liquidity preference is virtually absolute in the sense that almost everyoneprefers cash to holding a debt at so low a rate of interest. In this event, themonetary authority would have lost effective control."

- John Maynard Keynes, The General Theory

One of the many controversies regarding Keynesian economic theory centersaround the idea of a "liquidity trap." Apart from suggesting the potential risk,Keynes himself did not focus much of his analysis on the idea, so much of whatpasses for debate is based on the ideas of economists other than Keynes,particularly Keynes' contemporary John Hicks. In the Hicksian interpretation ofthe liquidity trap, monetary policy transmits its effect on the real economy byway of interest rates. In that view, the loss of monetary control occurs because,at some point, a further reduction of interest rates fails to stimulate additionaldemand for capital investment.

Alternatively, monetary policy might transmit its effect on the real economy bydirectly altering the quantity of funds available to lend. In that view, a liquiditytrap would be characterized by the failure of real investment and output toexpand in response to increases in the monetary base (currency and reserves).

In either case, the hallmark of a liquidity trap is that holdings of money become"infinitely elastic." As the monetary base is increased, banks, corporations, andindividuals simply choose to hold onto those additional money balances, with noeffect on the real economy. The typical Econ 101 chart of this is drawn in termsof "liquidity preference," that is, desired cash holdings plotted against interestrates. When interest rates are high, people choose to hold less cash because

cash doesn't earn interest. As interest rates decline toward zero (and especially ifthe Fed chooses to paybanks interest on cash reserves, which is presently thecase), there is no effective difference between holding riskless debt securities(say, Treasury bills) and riskless cash balances, so additional cash balances aresimply kept idle.
http://www.hussmanfunds.com/http://www.hussmanfunds.com/http://www.hussmanfunds.com/http://www.hussmanfunds.com/


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Velocity

A related way to think about a liquidity trap is in terms of monetary velocity:nominal GDP divided by the monetary base. (The identity, which is true bydefinition, is M * V = P * Y - the monetary base times velocity is equal to the pricelevel times real output).

Velocity is just the dollar value of GDP that the economy produces per dollarofmonetary base. You can also think of velocity as the number of times that onedollar "turns over" each year to purchase goods and services in the economy.Rising velocity implies that money is "turning over" more rapidly, so that

nominal GDP is increasing faster than the stock of money. If velocity rises,holding the quantity of money constant, you'll observe either growth in realoutput or inflation. Falling velocity implies that a given stock of money is beinghoarded, so that nominal GDP is growing slower than the stock of money. Ifvelocity falls, holding the quantity of money constant, you'll observe either adecline in real GDP or deflation.

The belief that an increase in the money supply will result in an increase in GDPrelies on the assumption that velocity will not decline in proportion to theincrease in money. Unfortunately for the proponents of "quantitative easing,"this assumption fails spectacularly in the data - both in the U.S. and

internationally - particularly at a zero interest rate.

How to Spot a Liquidity Trap

The chart below plots the velocity of the U.S. monetary base against interestrates since 1947. Since high money holdings correspond to low velocity, thegraph is simply the mirror image of the theoretical chart above.


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Few theoretical relationships in economics hold quite this well. Recall that aKeynesian liquidity trap occurs at the point when interest rates become so lowthat cash balances are passively held regardless of their size. The relationshipbetween interest rates and velocity therefore goes flat at low interest rates, sinceincreases in the money stock simply produce a proportional decline in velocity,

without requiring any further decline in yields. Notice the cluster of observationswhere the interest rate is zero? Those are the most recent data points.

One might argue that while short-term interest rates are essentially zero, long-term interest rates are not, which might leave some room for a "Hicksian" effectfrom QE - that is, a boost to investment and economic activity in response to afurther decline in long-term interest rates. The problem here is that longer-terminterest rates, in an expectations sense, are already essentially at zero. Theremaining yield on longer-term bonds is a risk premium that is commensurate

with U.S. interest-rate volatility (Japanese risk premiums are lower, but they alsohave nearly zero interest-rate variability). So QE at this point represents little butan effort to drive risk premiums to levels that are inadequate to compensateinvestors for risk. This is unlikely to go well. Moreover, as noted below, theprecise level of long-term interest rates is not the main constraint on borrowinghere. The key issues are the rational desire to reduce debt loads, and theinadequacy of profitable investment opportunities in an economy flooded with


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excess capacity.

One of the most fascinating aspects of the current debate about monetary policyis the belief that changes in the money stock are tightly related either to GDPgrowth or inflation at all. Look at the historical data and you will find no evidence

of it. Over the years, I've repeatedly emphasized that inflation is primarily areflection of fiscalpolicy - specifically, growth in the outstanding quantity ofgovernment liabilities, regardless of their form, in order to finance unproductivespending. Look at the experience of the 1970s (which followed large expansionsin transfer payments), as well as every historical hyperinflation, and you'll findmassive increases in government spending that were made without regard toproductivity (Germany's hyperinflation, for instance, was provoked bycontinuous wage payments to striking workers).

Likewise, real economic growth has no observable correlation with growth in themonetary base (the correlation is actually slightly negative but insignificant).

Rather, economic growth is the result of hundreds of millions of individualdecision-makers, each acting in their best interests to shift their consumptionplans, saving, and investment in response to desirable opportunities that theyface. Their behavior cannot simply be induced by changes in the money supplyor in interest rates, absent those desirable opportunities.

You can see why monetary-base manipulations have so little effect on GDP byexamining U.S. data since 1947. Expand the quantity of base money, and it turnsout that velocity falls in nearly direct proportion. The cluster of points at thebottom right reflect the most recent data.


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[Geek's Note: The slope of the relationship plotted above is approximately -1,while the Y intercept is just over 6%, which makes sense, and reflects the long-term growth of nominal GDP, virtually independent of variations in the monetary

base. For example, 6% growth in nominal GDP is consistent with 0% M and 6% V,5% M and 1% V, 10% M and -4% V, etc. There is somewhat more scatter in 3-year,2-year and 1-year charts, but it is randomscatter. If expansions in base moneywere correlated with predictably higher GDP growth, and contractions in basemoney were correlated with predictably lower GDP growth, the slope of the linewould be flatter and the fit would still be reasonably good. We don't observethis.]

Just to drive the point home, the chart below presents the same historicalrelationship in Japanesedata over the past two decades. One wonders whyanyone expects quantitative easing in the U.S. to be any less futile than it was in

Japan.


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Simply put, monetary policy is far less effective in affecting real (or evennominal) economic activity than investors seem to believe. The main effect of a

change in the monetary base is to change monetary velocity and short-terminterest rates. Once short-term interest rates drop to zero, further expansions inbase money simply induce a proportional collapse in velocity.

I should emphasize that the Federal Reserve does have an essentialrole inproviding liquidity during periods of crisis, such as bank runs, when people arerapidly converting bank deposits into currency. Undoubtedly, we would havepreferred the Fed to have provided that liquidity in recent years through open-market operations using Treasury securities, rather than outright purchases ofthe debt securities of insolvent financial institutions, which the public is now onthe hook to make whole. The Fed should not be in the insolvency bailout game.

Outside of open-market operations using Treasuries, Fed loans during a crisisshould be exactly that, loans - and preferably following Bagehot's Rule ("lendfreely but at a high rate of interest"). Moreover, those loans must be senior to anyobligation to bank bondholders - the public's claim should precede privateclaims. In any event, when liquidity constraints are truly binding, the Fed has anessential function in the economy.

At present, however, the governors of the Fed are creating massive distortions in


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the financial markets with little hope of improving real economic growth oremployment. There is no question that the Fed has the ability to affect the supplyof base money, and can affect the level of long-term interest rates, given asufficient volume of intervention. The real issue is that neither of these factors iscurrently imposing a binding constraint on economic growth, so there is no

benefit in relaxing them further. The Fed is pushing on a string.

Toy Blocks

Certain economic equations and regularities make it tempting to assume thatthere are simple cause-effect relationships that would allow a policy maker todirectly manipulate prices and output. While the Fed cancontrol the monetarybase, the behavior of prices and output is based on a whole range of factorsoutside of the Fed's control. Except at the shortest maturities, interest rates arealso a function of factors well beyond monetary policy.

Analysts and even policy makers often ignore equilibrium, preferring to thinkonly in terms of demand, or only in terms of supply. For example, it is widelybelieved that lower real interest rates will result in higher economic growth. Butin fact, the historical correlation between real interest rates and GDP growth hasbeen positive- on balance, higher real interest rates are associated with highereconomic growth over the following year. This is because higher rates reflectstrong demand for loans and an abundance of desirable investment projects. Ofcourse, nobody would propose a policy of raising real interest rates to stimulateeconomic activity, because they would recognize that higher real interest rateswere an effectof strong loan demand, and could not be used to causeit. Yetdespite the fact that loan demand is weak at present, due to the lack of desirable

investment projects and the desire to reduce debt loads (which has in turncontributed to keeping interest rates low), the Fed seems to believe that it caneliminate these problems simply by depressing interest rates further. Memo toBen Bernanke: Loan demand is inelastic here, and for good reason. Whateverhappened to thinking in terms of equilibrium?

Neither economic growth nor the demand for loans is a simple function ofinterest rates. If consumers wish to reduce their debt, and companies do nothave a desirable menu of potential investments, there is little benefit in reducinginterest rates by another percentage point, because the precise cost ofborrowing is not the issue. The current thinking by the FOMC seems to treat

individual economic actors as little, unthinking toy blocks that can be moved intothe desired positions at will. Instead, our policy makers should be carefullyexamining the constraints and interests that are important to people, and act in away that responsibly addresses those constraints.

A good example of this "toy block" thinking is the notion of forcing individuals tospend more and save less by increasing people's expectations about inflation(which would drive real interest rates to negative levels). As I noted last week, if


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one examines economic history, one quickly discovers that just as lower nominalinterest rates are associated with lower monetaryvelocity, negative real interestrates are associated with lower velocity of commodities(hoarding). Look at theprice of gold since 1975. When real interest rates have been negative (evensimply measured as the 3-month Treasury bill yield minus trailing annual CPI

inflation), gold prices have appreciated at a 20.7% annual rate. In contrast, whenreal interest rates have been positive, gold has appreciated at just 2.1% annually.The tendency toward commodity hoarding is particularly strong when economicconditions are very weak and desirable options for real investment are notavailable. When real interest rates have been negative and the PurchasingManagers Index has been below 50, the XAU gold index has appreciated at an85.7% annual rate, compared with a rate of just 0.1% when neither has been true.Despite these tendencies, investors should be aware that the volatility of goldstocks can often be intolerable, so finer methods of analysis are also essential.

Quantitative easing promises to have little effect except to provoke commodity

hoarding, a decline in bond yields to levels that reflect nothing but risk premiumsfor maturity risk, and an expansion in stock valuations to levels that have rarelybeen sustained for long (the current Shiller P/E of 22 for the S&P 500 hastypically been followed by 5- to 10-year total returns below 5% annually). The Fedis not helping the economy, it is encouraging a bubble in risky assets, and anincreasingly unstable one at that. The Fed has now placed itself in the positionwhere small changes in its announced policy could have disastrous effects on awhole range of financial markets. This is not sound economic thinking butmisguided tinkering with the stability of the economy.

Implications for Policy

In 1978, MIT economist Nathaniel Mass developed a framework for the liquiditytrap based on microeconomic theory - rational decisions made at the level ofindividual consumers and firms. The economic dynamics resulting from themodel he suggested seem strikingly familiar in the context of the recenteconomic downturn. They offer a useful way to think about the current economicenvironment and appropriate policy responses that might be taken.

"The theory revolves around a set of forces that for a period of time promotecumulative expansion of capital formation, but eventually lead to overexpansionof capital production capacity and then into a situation where excess capacity

strongly counteracts expansionary monetary policies.

"The capital boom followed by depression runs much longer than the usualshort-term business cycle, and is powerfully driven by capital investmentinteractions. The weak impact of monetary stimulus on real activity arisesbecause additional money has little force in stimulating additional capitalinvestment during a period of general overcapacity. Instead, money is withheld in


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idle balances when profitable investment opportunities are scarce."

In one illustration of the model, Mass introduces a monetary stimulus much likewhat Alan Greenspan engineered following the 2000-2002 recession (which wasalso preceded by an unusually large buildup of excess capacity, leading to an

investment-led downturn). Though Greenspan's easy-money policy didn't prompta great deal of business investment, it did help to fuel the expansion in anotherform of investment, specifically housing. Mass describes the resulting economicdynamics:

"Following the monetary intervention, relatively easy money provides a greaterincentive to order capital... But now the overcapacity that characterizes the peakin the production of capital goods reaches an even higher level than without thestimulus. This overcapacity eventually makes further investment even lessattractive and causes the decline in capital output to proceed from a higher peakand at a faster pace. Due to persistent excess capital which cannot be reduced

as fast as labor can be cut back to alleviate excess production, unemploymentactually remains higher on the average following the drop in production."

In what reads today as a further warning against Bernanke-style quantitativeeasing, Mass observed:

"Even aggressive monetary intervention can do little to correct excess capital...Once excess capacity develops, the forces that previously led to aggressiveexpansion are almost played out. Efforts to prolong high investment can produceeven more excess capital and lead to a more pronounced readjustment later."

Mass concluded his 1978 paper with an observation from economist RobertGordon:

"Why was the recovery of the 1930's so slow and halting in the United States,and why did it stop so far short of full employment? We have seen that thetrouble lay primarily in the lack of inducement to invest. Even with abnormallylow interest rates, the economy was unable to generate a volume of investmenthigh enough to raise aggregate demand to the full employment level."

I've generally been critical of Keynes' willingness to advocate governmentspending regardless of its quality, which focused too little on the long-term

effects of diverting private resources to potentially unproductive uses. Hisremark that "In the long-run we are all dead" was a reflection of this indifference.Still, I do believe that fiscal responses canbe useful in a protracted economicdownturn, and can include projects such as public infrastructure, incentives forresearch and development, and investment incentives in sectors that are notburdened with overcapacity. Additional deficit spending is harmful when it failsto produce a stream of future output sufficient to service the debt, so theexpected productivityof these projects is the essential consideration. Given


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present economic conditions, it appears clear that Keynes was right about thedangers of easy monetary policy when an economic downturn results fromovercapacity. As I noted last, better options are available on the fiscal menu.

A Primer on Quantitative Easing: What Is It and Will It Save the

Economy?By Hans Wagner

Created 10/29/2010 - 18:28

Quantitative Easing (QE) is a hot issue. But even though the term is used frequently byjournalists, analysts and investors, most people are only repeating what they heardsomeone else say.

Let's see if we can shed some light on QE: the challenges the Fed is facing, the actionsit's likely to take, and what an investor should do to prepare.

The upcoming announcement from the Federal Reserve will be one of the mostimportant in recent months. The question is what you should do to be ready when thenews is announced.

Some BasicsQuantitative easing is a strategy employed by a central bank like the Federal Reserve toadd to the quantity of money in circulation. The premise (which is largely theoretical anduntested) is that if money supply is increased faster than the growth rate of GrossDomestic Product (GDP), the economy will grow.

To understand the rationale behind the strategy, it helps to look at the basic relationshipamong GDP, money supply and the velocity of money.

In general, GDP equals money in circulation (M) times the velocity of the money throughthe economy (V):

GDP = M * V

Velocity is the speed at which money passes through the hands of one person orcompany to another. When money is spent quickly, it encourages growth in GDP.When money is saved and not spent, the GDP of the country slows.Today, one of theproblems the United States faces is people and companies are saving their money andpaying down debt instead of spending it. When people spend less and save more, thevelocity of money falls and drags down economic growth.

Through quantitative easing, the Federal Reserve will try to counteract falling velocity byincreasing the money supply. It has two primary tools with which to do it.


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The first way the Fed manages money supply is via the federal funds rate. Banks withexcess reserves can lend money to other banks that need additional reserves beforeclosing their books for the day. The federal funds rate is the interest rate the bankscharge each other for these overnight transactions.

The Federal Reserve sets the federal funds rate. As one of the most important interestrates in the world, it is widely quoted in the press.

The current fed funds rate is between 0% and 0.25%. Essentially banks can "borrow" ata very low rate of 0 0.25%, making their cost of funds very low. Theoretically, thisshould encourage banks to lend funds to individuals and businesses at higher rates -- ifthey can borrow at 0% and lend to someone else at more than 0%, they make money.

The second tool the Fed uses is the open market operation (OMO). The Fed uses

OMOs to buy or sell securities that banks generally own -- mortgages, Treasury bonds,and corporate bonds. When the Federal Reserve buys securities, they trade the securityfor cash and increase the money supply. When they sell securities back to banks, theydecrease the money supply.

In the past, the Federal Reserve has not resorted to this approach to manage thesupply of money in the economy. But starting in 2008, it started buying large amountsof mortgage-backed securities (MBS) and Treasuries in order to add more money to theeconomy and help stabilize the banks.

Where We Are Today

Since the Federal Reserve has lowered the fed funds rate to 0

0.25%, banks haveaccess to cheap money. The Fed was hoping that access to cheap money wouldencourage the banks to lend to their customers at reasonable rates. But it hasn't beenthat easy. The Fed has run into two problems.

First, many companies and individuals are afraid to borrow. They lack confidence in theeconomy. They prefer to save their cash and pay down existing debt. Thisphenomenon is reflected in the rising savings rate and the falling level of consumer andcorporate loans. Not only has money supply not increased, but increased saving hasslowed the velocity of money through the economy.

Second, banks are afraid to lend because they're afraid they won't get it back. Shouldthe company or individual run into financial difficulty, the bank may be stuck with a loanloss. So instead of investing in loans, the banks are turning back around and buyinghigh-quality securities like long-term Treasury bonds. Today, a 10-year Treasury ispaying a yield of around 2.5%. With a cost of funds of 0.25%, this gives the bank aninterest rate spread of 2.25% -- a very nice profit with almost no risk.


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All of this means the Federal Reserve's attempt to stimulate the economy with low shortterm rates is not achieving its desired goal. The economy remains in slow growthmode.

And relatively high long-term Treasury yields (when compared to 0% short-term yields)

have perversely created an incentive for banks to stop making loans except to the U.S.Treasury.

How Will Quantitative Easing Help?The Federal Reserve recognizes that banks are using very cheap short-term money topurchase longer-term securities and pocketing the difference in interest income. So theFederal Reserve has decided it wants to drive down longer term rates and remove theincentive to buy Treasuries.

If the Federal Reserve buys enough 2-year, 3-year, 5-year and 10-year Treasuries, theyforce an increase in their prices. And bond prices are inversely related to bond yields:

when prices go up, yields go down. A lower yield means banks cannot make as muchmoney using the overnight money at 0 0.25% and buying long-term Treasury bonds,since the yield on those bonds will be pushed lower and lower.

The hope is the banks will then be encouraged to lend more, thereby stimulating theeconomy.

The Bottom LineMost people expect the Federal Reserve to announce they will add another $1 trillion innew money to the economy by buying Treasuries. I don't think the Fed will go that farthat soon. Announcing a large number commits the Fed to buying that many Treasuries

and it doesn't give it the flexibility it needs to adjust the program as its effects ripplethrough the economy.

Rather, I believe the Fed will announce it stands ready to purchase 2, 3, 5 and 10-yearsecurities in blocks of about $100 billion a month. The exact makeup will depend on theFed's view of where it can get the biggest benefit for the money spent.

By carrying out the quantitative easing over a series of months, the Federal Reserveallows itself some flexibility to adjust purchases based on updated forecasts of theeconomy. It also allows the Fed to communicate its intentions over time, cutting downon the number of surprises inflicted on the fragile economy.

If the Federal Reserve buys $100 billion of intermediate-term Treasuries each month, itwill place downward pressure on the interest rates of the Treasuries they purchase. Butbecause the Fed has already telegraphed its intentions to the market, rates have fallensignificantly in anticipation of the official quantitative easing announcement. Therefore,we are likely to see a brief move up in longer-term rates as bond traders close out theirprofitable positions.


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After the initial shake out in the stock and bond markets, it's certain that economist willcontinually monitor the economy to gauge QE's effectiveness. If the program isencouraging more lending, the economy should start to grow faster. But if lending doesnot pick up, it is telling us borrowers and/or lenders lack confidence in the future and areunwilling to compromise their balance sheets. If this happens, the economy will remain

in slow growth mode.

Fed Chairman Ben Bernanke is sure to make regular announcements on the state ofthe program. If he indicates they will buy more Treasuries in the future, it means theeconomy is not responding as well as he hoped, and he wants to add more money tothe system. If he suggests the Fed will reduce purchases, it indicates his belief thatquantitative easing is working and the economy is improving.

As far as trading, the short-term downside vastly outweighs the upside, if only becauseof uncertainty. If you are a short-term trader, you might want to move to cash to avoidthe inevitable volatility that will ensue, as this is a sell on the news event.

If you are a longer-term investor, be sure to add some downside protection to yourportfolio. You may also want to own some longer-term Treasuries, since the wholepoint of QE is to drive up the price of those specific securities. Don't be prepared to holdthem forever, though. At some point (hopefully), the economy will grow again and bondprices will come back down.

This round of quantitative easing will be studied for years. We are in uncharted territoryand the risks should not be underestimated. Capital preservation is important tosuccess. Take steps to reduce your risk until we have a better idea of the longer termeffects of this next round of QE.


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Standard CFTC disclaimer:

The risk of loss in trading commodities can be substantial. You should therefore carefully considerwhether such trading is suitable for you in light of your financial condition.

The high degree of leverage that is often obtainable in commodity trading can work against you as well asfor you. The use of leverage can lead to large losses as well as gains. In some cases, managedcommodity accounts are subject to substantial charges for management and advisory fees. It may benecessary for those accounts that are subject to these charges to make substantial trading profits toavoid depletion or exhaustion of their assets.

The disclosure document contains a complete description of the principal risk factors and each fee to becharged to your account by the commodity trading advisor ("CTA"). The regulations of the CommodityFutures Trading Commission ("CFTC") require that prospective clients of a CTA receive a disclosuredocument when they are solicited to enter into an agreement whereby the CTA will direct or guide theclient's commodity interest trading and that certain risk factors be highlighted. This disclosure documentwill be provided via electronic mail or hard copy upon request to any interested parties. This brief

statement cannot disclose all of the risks and other significant aspects of the commodity markets.Therefore, you should examine the disclosure document and study it carefully to determine whether suchtrading is appropriate for you in light of your financial condition.The CFTC has not passed upon the merits of participating in this trading program nor on the adequacy oraccuracy of the disclosure document. We are required to provide other disclosure statements to youbefore a commodity account may be opened for you.

Written by James M. Edwards

602-441-4303

[email protected]

Please do NOT redistribute the letter.

Documents

SmartChart_November 6 2010