James G. Rickards, Senior Managing Director, Tangent Capital Partners LLC, who wrote “Currency Wars: The Making of the Next Global Crisis” testified before the Subcommittee on Economic Policy of the U.S. Senate on March 28, 2012.

He made some important observations as to why the Fed continues to print money and keep interest rates at historical lows.

The Fed is trying to create slow, gradual inflation and negative real interest rates (e.g. interest rates that are lower than inflation) over a ten to fifteen year period to erase the burden of government debt without triggering hyperinflation or defaulting on the debt.

The Fed’s goal is to maintain nominal interest rates in the range of zero to 2% - while seeking inflation in the range of 4%.  This results in negative real interest rates which encourage individuals and businesses to borrow more money and create an “inflation scare” to stimulate more consumer spending and reduce the real burden of government debt. 

Back in November, many believed we were on the verge of a collapse of the European banking system. There were runs on PIIGS banks, most money market funds had stopped lending to them, and they did not have sufficient quality collateral to borrow what they needed from the ECB. They also needed to meet new, more stringent EU bank capital rules by June 2012.  

Weak banks were forced to sell PIIGS bonds and other assets to raise cash.  They could not borrow enough and could not raise enough capital via stock offerings at reasonable rates.  This helped push PIIGS bond interest rates higher.

The ECB responded with its LTRO (Long Term Refinance Operation) and prevented the collapse of the European banking system by acting as the lender of last resort - which is what it is supposed to do.  This helped bring PIIGS interest rates down, slow the run on PIIGS banks, and pushed equities higher on the belief that the crisis had been averted and that some of this borrowed money would find its way into the financial markets and be used to  purchase PIIGS bonds.  This has pushed equities higher. Bond investors so far aren't buying it.  Bond prices have been going higher along with stock prices.

I found an article I want to share with you that does a good job of very simply explaining why John Mauldin has made the observation that "Japan is a bug in search of a windshield".  I have posted a link to this article below.

It is estimated that if Japan’s interest rates on its bonds goes up by just 2%, that the interest and principal payments on its debt will use up all its tax revenues.  There will be no revenue left to fund their current spending.  There is a limit on how much money any government can print before investors drive interest rates up on their debt.

Japan's situation is similar to a neighbor needing most of their salary to pay the minimum payments on their credit cards and their mortgage each month.  They have turned to their parents to loan them the difference at a very low interest rate. However, their parents are about to retire and can no longer afford to lend them all the money they need.  Who do you think will lend money to them for food and other living expenses when their debt is so high relative to their income?  Speculators might for a while, but definitely not for 1% interest.  As interest rates increase to compensate outside lenders for their risk, their budget shortfall and debt will grow dramatically.  Your neighbor will be forced to default on their debt and declare bankruptcy.  

U.S. economic growth has surprised to the upside.  The S&P 500 has rallied up 5.29% this past month and financial stress in Europe is dropping.  Insolvent countries are lending money to insolvent banks, so the fundamental risks in Europe are still very high.  However, it is possible now that the European Central Bank is loaning more than one trillion euros to European banks at very low rates on basically any collateral, that some of this printed money is finding its way into the financial markets. At the least, it appears to have bought Europe some extra time.  This is causing stock prices to “melt up” on low volume.

Some long term trend buy signals have triggered so we have been investing money back into the market for clients who can tolerate the risk - realizing that the risk of a whipsaw (e.g. stock prices break into bull market territory and then head back down) is high.  Stock prices go down much more quickly than they go up.

Successful investing requires us to be objective and change our investment strategy as the facts change.