You wouldn't know it by watching the stock market, but the bond market understands that if the leaders in Europe do not come up with a serious plan that is immediately actionable in the coming days, the entire global monetary system could crumble.  Stocks closed higher on the day yesterday, but there were signs of cracks in the credit markets both in the U.S. and in Europe.  High yield bonds, investment grade bonds, as well as nearly every EU member's bonds all were lower on a day that saw the stock market rally as much as 1%.

The cracks in the credit markets are becoming obvious as the ratings agencies have all lowered their outlook to negative for US debt.  We've also seen the ratings of several periphery EU countries cut and there are rumors that France's 'AAA' rating may be in jeopardy.  Bonds also sold off late in the day after Fitch said that the U.K. has no more room for further economic shocks if it wants to keep its own 'AAA' rating.

After the market closed, S&P downgraded over two dozen global banks, which immediately increased their funding costs and will put further pressure on their ability to meet their own liquidity needs.  The reasoning behind the downgrade was a revision in S&P's "stress" model, which indicated the banks do not have enough capital should their "assets" run into additional problems.

This morning the markets are set to rocket higher as the Central Banks are stepping in to once again boost the availability of money to the heavily indebted banks.  First China cut its reserve requirements for its banks, which would allow its banks to lend more money.  Moments ago, several global central banks along with the Fed announced a plan to strengthen the global dollar swap lines.  (We discussed these swap lines in late October.) 

So why does all of this matter?  First of all, we have to remember one thing -- The EU and the US have been able to survive the past decade or so by using a Debt Ponzi Scheme.  Look at how interconnected each of the key players are to each other.  If you haven't done so already or need a refresher, I would encourage you to read this article before you continue.

I've been trying to sketch out how the Global Financial System operates for quite some time.  I wanted to put into a picture why I strongly believe that no matter what happens over the short-term, the global debt bubble cannot end happily.  It will get ugly when this system no longer is sustainable.  Like all Ponzi Schemes, they work well as long as new money continues to flow in.  That money is used to pay the original "investors" back.  Once the money stops flowing in, the scheme quickly crumbles.

Here is my best illustration of how our monetary system works (click on image for larger view). 

There are a lot of moving parts here, but what struck me is how interconnected every thing really is.  To understand what is happening we need to focus on where the EU Member Countries are getting their funding.  They'd been surviving by selling bonds to EU Banks, US Banks, Other International Banks, and Other Foreign Investors.  With the problems in the PIIGS countries (Portugal, Italy, Ireland, Greece, & Spain) causing the bonds to drop in value this has hurt all of those that bought their bonds.  The heaviest purchasers (EU Banks & US Banks) are now running into problems, so their funding source has been greatly reduced.

Given the problems with the long-time funding source for the EU countries, the EFSF was created.  We've discussed this "bazooka", which remains 'long on words, short on details' many times.  In the flow chart above I summarized the most popular plan for the EFSF.  For more details on the EFSF portion of this plan, click here.

The problems at the banks has gone beyond they fact that they can no longer fund the EU governments by purchasing their bonds.  They are now having their own liquidity problems, which has led for many people to wonder how long before the ECB and the Fed step in to provide further liquidity.  The action this morning is not about being able to buy EU Bonds, it's about their survival and their ability to continue providing their primary function -- having money available to meet their depositors demands.

When you combine the coordinated central bank action this morning, with China's easing you can see why there is a rally.  Because China does not disclose very much about their finances (and for simplicity's sake) I could not include them on this flow chart.  They are grouped in the "Foreign Investors & Other Countries" category.  It does appear that they follow the same type of monetary system as the EU & US (but in a much bigger way).  They create money via their central bank, funnel it to their own banks, those banks buy their bonds as well as other countries bonds (like the EU & US), and the bond proceeds go back to the government.

Basically, this mornings actions by China and the other central banks freed up some of the capital to solve a SHORT-TERM problem.  In the bigger picture, the only thing left for this Ponzi Scheme to survive is to turn to more money creation (Quantitative Easing).  I fully expect both the Fed and the ECB to resort to that in the near future.  We'll save the discussion on Quantitative Easing for another day.

What needs to be realized is something that I could not include on the flow chart -- the consequences of money creation that basically stays inside of this nearly closed loop system.  (If you really believe that the money would flow from the government to the citizens in a positive fashion, please check out "The Grand Experiment".)

What we have seen is that the money creation has sparked inflation, which hurts those the most living on the fringe.  In August we discussed the $1.2 Trillion in secret, emergency loans the Fed provided to banks around the world.  We are now learning that the amount of guarantees the Fed made in addition to the loans was over $7 Trillion.  In addition to that, Bloomberg has discovered that banks made an estimated $13B in profits from these loans.

At this point in the Social Cycle we cannot afford to have the central banks turning back to money creation in order to save the Ponzi Scheme.  Granted, we can't just let banks fail leaving the depositors without any money, but the actions by the central banks are designed to save the banks, not the depositors.  The reason the banks are in so much trouble is because they became investors (or speculators) instead of lenders with the deposits.  Why is it some investors (like us) are fully responsible for bad investments, yet the banks are bailed out?

Today's news does nothing to change the fact that the Ponzi Scheme is running out of time (keep in mind that this type of 'coordinated' move was made several times in 2008 & it was a WARNING that the banks saw serious problems).  Major sacrifices and restructurings will need to occur to save the Global Financial System.  That will be a painful time for investors and many citizens that are relying on the government for their standard of living.  Our goal is to navigate this difficult time as best we can so that when it all blows up (and it will) we have most of our capital in tact to take advantage of the opportunities on the other side.

It's certainly not fun and definitely not easy, but it will be worth it in the long run.

The comments and posts published in the SEM Trader's Blog ARE NOT investment recommendations. They can NEVER be considered as trading calls or advices. If you decide to use the information offered here for your real trading it is at your own risk.

Investing in the stock or bond markets involves risk and may not be suitable for all investors.  Before making any investment decisions you should carefully consider your investment objectives, level of experience and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with your investments and seek advice from an independent financial advisor if you have any doubts.  All investments involve risk including those managed by Strategic Equity Management.

Opinions expressed at www.stratequity.com are those of the individual authors and do not necessarily represent the opinion of Strategic Equity Management or its management.  Any opinions, news, research, analysis, prices or other information contained on this website, by Strategic Equity Management, its employees, partners or contributors, is provided as general market commentary and does not constitute investment advice. Strategic Equity Management will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.

The use of this website constitutes acceptance of our user agreement.  Past performance is NOT indicative of future results.