PIIGS Crisis Is Benefiting Japan.

Marc Faber's "bowl of liquidity" analogy, showed us how as a result of the European sovereign debt crisis, money could flow out of PIIGS debt and into equities. I wanted to provide a little more color given the events of the past couple weeks as the crisis has moved from Ireland and Portugal to Spain and Italy.

In the chart above, tells a different story. Here, the Euro Stoxx chart is in orange, the S&P 500 is in white, and the Nikkei is in green. And we see that since the Spain/Germany spread bottomed on October 26, the Euro Stoxx is down 6.5%, the S&P 500 is up 0.2%, and the Nikkei is up a whopping 8.0%! Whoa, what's going on?

What I believe to be happening is that with the current crisis being one more of solvency than liquidity (though Spain may have something to say about that), instead of markets being simply "risk on" or "risk off," idiosyncratic factors are coming into play as global asset allocators evaluate their options. Due to the PIIGS crisis, borrowing costs are rising for the European sovereign market -- yesterday was scary because not only did Spanish 10-year yields rise 25bps, but German 10-year yields also rose -- which feeds back into the private market for European borrowers in the form of more expensive credit. Austerity measures impact growth prospects. And allocators, aware of this, are moving money out of Europe -- not just sovereign debt but equities as well. European-focused funds may be experiencing redemptions, and oftentimes portfolio managers are forced to sell their most valuable assets that still have liquidity (equities) instead of the distressed ones they'd like to unload (sovereign debt). And this money is finding its way not just into real safe havens like US, German, and Japanese debt, but the US and Japanese equity markets as well. After being neglected for so long by investors, the smallest trickle of inflows into the Japanese equity market could create a surge along the likes of the commodities market in the earlier part of the last decade.

This is not to say that it's time to load the boat with Japanese and US equities. The crisis has still not passed. If Spain or Italy seizes up it could do untold damage to all asset markets with the liquidity crisis returning for awhile. But I believe that correlations are breaking down as the crisis shifts from one of liquidity to one of solvency, and when solvency crises intermittently create liquidity crises it's time for investors to think about what to own while assets with true value are being treated no differently than ones that truly might go to zero.

The Fed Could Be Wrong This Time.

Every precious metals investor should be concerned about China, one of the world's fastest growing economies, raising its rates and rising yields. Changes in the rates affect stock prices. China is leading the world and we can see the fears are profound as sell-offs this week were much stronger than any of the relief rallies. If China’s market corrects then the commodity market, which was fueling the equity market, could experience a severe correction. It's a domino effect.

Despite the Fed’s enthusiastic plan to monetize debt and artificially keep interest rates low through bond purchases, yields have risen aggressively for the last 13 weeks. The QE2 program was designed to lower interest rates to improve borrowing and liquidity. Instead the opposite occurred, QE2 is initiating higher borrowing costs. I don’t believe it is coincidence that Ireland’s debt problems surfaced following QE2. China is now on the verge of raising rates to combat imported cheap dollars to bid up Chinese assets, which is putting pressure on markets globally. Rising rates kills equity and commodity markets, which are heavily built on margin borrowing.

The Long Term Treasury ETF (TLT) (above)broke through the trend it had from May until the end of August. This previous trend was largely a result of a deflationary crisis where investors ran from risky assets like the euro to the dollar, and long-term Treasuries were pushing yields to ridiculously low levels. As fear in the markets decreased, due to a temporary stabilization in Europe and the US, investors ran to equities and commodities.

International reaction to QE2 has not been positive. There is an increased risk of emerging markets combating inflation, which may slow down the global recovery. Fears of China and emerging markets raising rates make investors unsure where to turn.

Asset classes have reacted negatively to China’s expected move. Distribution is apparent through many sectors and many international markets. Rising interest rates have a direct influence on corporate profits and prices of commodities and equities.

When studying interest rates it's not the level that is important, it's the rate of change. Interest rates have had a dramatic increase these past two months and we may see that affecting the fundamentals in the economy shortly.

The recent downgrade on US debt from China, signals demand for US debt has been waning. This rise in interest rates puts further pressure on the recovery as the cost of borrowing increases. Economic conditions are worsening in Europe and emerging markets in reaction to quantitative easing and imported inflation. Concerns of sovereign debt issues are weighing in Europe. As yields rise so do defaults and margin calls.

If the 200-day is unable to hold the bond decline and continue to collapse, then rising interest rates could negatively affect the economic recovery. Borrowing costs to insure government debt are reaching record levels internationally. Ireland is expected to take a bailout. Greece, Spain, and Portugal are in danger as well.

Commodities have significantly moved higher along with the equity market for September and October as investors left Treasuries to return to risky assets due to the fear of debt monetization through QE2. Global equity markets have been rising. But the question is, how long? This makes investors reluctant to take on debt, which is the exact opposite of what the Fed’s goals were. Rising yields could lead to a liquidity trap and deflationary pressures.

Bubbles, Signs.. And All Things Nice!

What other bubbles are lurking out there in the global economy?

1. Gold: The price of gold bullion has risen from $294 an ounce in 1998 to $1,404 last week, an increase of 377%. "It's the biggest, baddest bubble of them all," says Robert Wiedemer, author of Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown. Gold has no intrinsic value. A telltale indicator that gold is a bubble: incessant cocktail party chatter about buying gold and endless investment banks offering to sell gold derivatives. The SPDR Gold Trust ETF (look to your left) is up 28% since the beginning of the year.

2. Real estate in China: Chinese real estate prices are up only 9.1% this year, which may seem more frothy than bubbly. But rising prices are generating rising demand, which is a clear sign of a bubble, says Vikram Mansharamani, whose book, Boombustology: Spotting Financial Bubbles Before They Burst, will be published early next year. The participation of amateur investors like waiters and maids in the property boom is a clear sign of a property bubble in China. The fact that developers are building more apartments than there are buyers is another giveaway.

3. Alternative energy: Solar technology is still uneconomic, yet governments all over the world are subsidizing solar energy firms. "There are plenty of people who shouldn't be in the solar energy industry who are," says Mansharamani. Do we really need 250 venture-capital-backed solar cell companies? The Market Sectors Solar Energy ETF had a 100% gain this year, before dropping back.

4. Commodities: Blame it on the weather, China or the dollar or the Fed, but commodities have shot higher in recent months. Wheat is up 60% this year, and other food commodities like corn have also risen dramatically. "The focus is on the food category for bubbles," says Wiedemer, but industrial metals like copper are also very frothy.

5. Emerging market stocks: As an asset class, these shares have risen 146% in the past two years. "We're only halfway along the way to a gigantic eventual bubble in the emerging markets," says Barton Biggs, the former Morgan Stanley Asset Management chairman who accurately predicted the US stock market bubble in the late 1990s. These countries, such as Indonesia, Australia, Russia and Brazil, are growing wildly even though there's no growth in the world economy. Much of their gains is backed by commodity prices, which are also a bubble (see item No. 4). "I have every reason to believe this will turn into a bubble," says Mansharamani.

6. The US dollar: Although the dollar is down 10% against the euro so far this year, Wiedemer believes the greenback is firmly in bubble territory. He believes it will pop when foreigners stop buying US assets such as stocks and bonds. "Foreigners say, 'I'm worried about inflation -- you're going to pay me back in dollars worth less than when I invested'." While China may hold its dollar bonds forever, he says, pension funds in Japan and insurance companies in Europe will start dumping dollars as US inflation climbs.

7. US government debt: "When this bubble pops you're out of bubbles -- nothing is too big to fail any more," says Wiedemer. The debt bubble is growing very rapidly and will continue to grow, he says. Basically, there's no way the US government can ever pay back the $13.7 trillion it currently owes (mainly to foreigners), and eventually they will stop buying. The bubble pops when the government has trouble selling its debt -- just like Ireland and Greece are experiencing at the moment. Instead of borrowing money, the government starts printing money, which is what's happening now. The Fed's balance sheet has gone from $800 billion in 2008 to $2.2 trillion, and the central bank just announced it was printing another $600 billion. Says Wiedemer: "The medicine starts to become poison." - All these, just when bewildered, lost uncles and aunties are learning from your local research houses' market outlook roadshows about what's QE2!

USD, The Confetti In Wallets After QE 2.

Forget about fundamentals or technicals: just follow the bouncing buck.

Strategists emphasize that a new theme has emerged in the investment markets, which is that the risk-on/risk-off trade is taking its cue increasingly from the US dollar. The correlations, market pros say, are high, intensifying, and actually now unprecedented.

For example, according to Gluskin Sheff’s David Rosenberg, over the past two months, 90% of the time that the dollar moved in one direction, the S&P 500 moved in the other. The inverse correlation, over the same time period between the dollar and emerging market equities, was 92%; it’s now running at 95% for the CRB index.

Interesting positive correlations are also now firming dramatically. For instance, over the past two months, the dollar and corporate spreads moved in the same direction 80% of the time. The dollar and the VIX, which tracks expected volatility in the stock market, moved in the same direction 80% of the time.

In other words, ignore the politics, economic data and technical levels. Maybe right now all money-making traders and investors need to do is follow the dollar. It’s a simple tune whistling through the canyons of lower Manhattan: dollar down, everything else up.

“Hard to believe it’s that easy, but this seems to be the environment that Ben Bernanke have managed to create in their quest to reflate the global economy,” Rosenberg says.

Historically, say strategists, these correlations weren’t this pronounced, but that changed when the Federal Reserve began buying Treasury securities. Last week, the Fed announced that it will print another $600 billion to buy Treasuries through mid-2011. That’s in addition to the roughly $2 trillion it printed to buy Treasuries and mortgage debt during the financial crisis.

The point of the program is to keep long term interest rates low, encouraging borrowing and spending by consumers and companies. The idea, if Bernanke and his FOMC allies are right, is that yields will tumble and people will start buying homes again. Expecting greater inflation ahead, they’ll also buy more stuff at the mall. In turn, companies can start hiring and unemployment will fall.

Of course, investors also know that vastly increasing the supply of dollars means each dollar is worth less when measured against other things. So they’re concerned about the real worth of all that confetti in their wallets, and they’re looking to protect themselves by diversifying into other assets.

Since August 27, when Bernanke suggested that another round of monetary stimulus was on the way, the dollar index (DXY), a measure of the dollar against a basket of currencies, is down 8.4% Gold was up 12.5%.

“This is part of the same trade we’ve seen since March 18, 2009 when Bernanke said he was going to start buying Treasuries,” says Miller Tabak’s Peter Boockvar, as investors look to protect themselves from a lower dollar by loading up on the stocks of big exporters, emerging market equities, hard assets, and foreign currencies. “Maybe now it’s just intensified,” he says.

Critically, says S&P’s Alec Young, the point isn’t just that the Fed is printing another $600 billion, but that central bankers also left the door open to keep printing more money if necessary.

“That was a green light for the risk trade,” he says. “It means an open-ended amount of dollar printing. So the dollar is tanking and commodities, gold, bonds and stocks go up. It reinforces all those trades.”

At some point a few months from now, Young says, investors will want to see real evidence that all this monetary experimentation worked. If they don’t see the economic benefits then they could sell stocks and commodities in anticipation of another leg down. But, for now, he argues, it’s unwise to violate the first rule of Investing 101: Don’t fight the Fed.

“There could be a correction next year when people are disappointed at what this actually accomplished,” Young says. “But that’s the next trade. Right now, the Fed gets the benefit of the doubt. You could be right and all this won’t do any economic good but, in the meantime, you could also miss out on the rally.”

But, if the risk-on/risk-off trade is taking its cue increasingly from the U.S. dollar, when might that relationship fade?

That happens, says Young, when we generate a stable, self-sustaining recovery. “It breaks when the U.S. economy finally gets on its feet and doesn’t need the Fed to keep printing a ton of money,” he says. “If QE2 works then that marks some kind of bottom for the dollar.”