Prior to the financial crisis, the Federal Reserve bought minuscule amounts of U.S. government debt. In 2011, the Federal Reserve bought 61% of all net U.S. Treasuries issued (source: Wall Street Journal, Mar. 27, 2012).

Reread that again, dear reader, to absorb its full meaning—61% of all issued U.S. Treasuries were bought by the Federal Reserve last year.

Before the financial crisis, it was foreign countries that were the major purchasers of U.S. government debt. Since then, many countries have reduced their purchases of U.S. government debt, especially China.

In December of 2011, all foreign countries were net sellers of U.S. government debt to the tune of $21.0 billion (source: Forbes). South Korea reduced its holdings of U.S. government debt and its holdings of U.S. dollars from 63.7% of foreign currencies to 60.5% of foreign currencies.

Over the last five years, China purchased an average of 63% of all newly issued U.S. government debt. In 2010, it dropped to 45% of all newly issued U.S. government debt and now China is purchasing only 15% (source: Wall Street Journal, Mar. 27, 2012).

With the Federal Reserve being the largest buyer of U.S. Treasuries, it creates the false impression that the U.S. government debt market is functioning normally and that there is ample demand worldwide for it. However, if the Federal Reserve stops buying, who will be there to purchase U.S. government debt?

In the U.S. government debt market, like in all other debt markets, the higher the demand, the lower the interest rate one needs to pay on their debt. The Federal Reserve is creating its own demand, thus keeping interest rates low.

Of course, as I mentioned in these pages last week, each full percentage point rise (one percent) rise in interest rates will cost the U.S. government approximately $150 billion more in interest. It is no wonder the Federal Reserve is attempting to keep interest rates low on U.S. government debt?

The other consequence of the Fed buying U.S. government debt is that it forces the American banks to buy short-term U.S. government debt. The Federal Reserve is currently conducting “Operation Twist,” which is selling short-term U.S. government debt in exchange for long-term U.S. government debt.

Well, someone has to buy that short-term debt, and that someone is a participant with no choice in the matter: the large U.S. banks. So, U.S. banks buy the short-term U.S. government debt from the Federal Reserve, and the Federal Reserve takes the proceeds and purchases long-term U.S. government debt in order to keep long-term rates low.

In the first two months of 2012, large U.S. banks bought more short-term U.S. government debt than in all of 2011, as Operation Twist ramped up. In the first two months of 2012, $78.2 billion was purchased, bringing the total amount of short-term U.S. government debt held by the large U.S. banks to an eye-popping $1.78 trillion (source: Bloomberg).

If short-term rates were to rise due to inflation (likely) or an economic recovery (unlikely), then U.S. banks would lose billions of dollars from owning short-term U.S. government debt that pays almost zero interest. Who would then bail out the U.S. banks should this occur, dear reader? You guessed it. (Please see: The Land Debt Built.)

The U.S. government debt market is currently very calm thanks to the Federal Reserve. If the Federal Reserve stops buying U.S. government debt and foreigners continue to walk away from the U.S. government debt market, then who will buy the debt? The only choice the Federal Reserve has in a bid to keep rates low is to print more money and buy more U.S. government debt to stabilize the market. This is why I see the current correction in the 10-year old bull market in gold as such a great opportunity.

Michael’s Personal Notes:

Frustrated with what they viewed as being ignored by the West and not having a prominent role in institutions like the World Bank and the International Monetary Fund, Brazil, Russia, India, China and South Africa (also known as the BRICS countries) held their first summit in Russia in 2009 to discuss their common interests.

Just three short years later in 2012 in New Delhi, the BRICS countries emerged from their meetings to declare that trade between their countries would take place in their own currencies, doing away with the use of the reserve U.S. dollar.

Just to be clear, dear reader; it takes time, money and effort to set up bank exchanges that would allow them to trade in their own currencies. It is much easier to trade in the world’s reserve currency, the U.S. dollar, than take this route.

This is significant as well because the BRICS countries represent 40% of the world’s population and 20% of the world’s gross domestic product (GDP). There is no question however, that the BRICS countries are growing their portion of world GDP faster than the West, which means that, even in a decade, the BRICS countries are going to represent a lot more than 20% of the world’s GDP.

Another major objective that was announced at this year’s summit was to increase trade among the BRICS countries themselves, in order to reduce the influence of exporting to countries in Europe and to the U.S. Trade among the BRICS countries is growing at a 28% annual rate and is expected to double in just a few years from the $230 billion worth of trade being transacted today in the BRICS countries, increasing their GDP influence.

The most startling announcement to come from the summit was the formal proposal for studying the creation of a BRICS development bank that would offer an alternative to the U.S.-dominated World Bank. The finance ministers of the BRICS countries were asked to study the possibility and report back with a proposal at next year’s summit.

The proposed development bank would allow not only member BRICS countries to apply for loans for infrastructure projects and other development initiatives, but also all developing countries in the world.

Of course, should such a bank be created, it would need to be denominated in a reserve currency, so that loans could be issued in that reserve currency to developing countries around the world.

As a surprise to no one, even though the subject has not been discussed, there is no doubt that China wants its yuan to be the reserve currency for the BRICS development bank, as China continues its quest to have the yuan become an international currency, on par with the U.S. dollar and the euro. However, considering how culturally diverse the BRICS countries are, they may develop a new currency, which will still require that China significantly back it with its yuan.

The BRICS countries represent the fastest growing countries in the world. Although only 20% of the world’s GDP today, this GDP number is rising rapidly and, as a consequence, so will the BRICS countries’ influence. The agreement to trade in their currencies and to create a BRICS development bank is a direct assault on the U.S. dollar.

As I’ve said all along, dear reader, the reserve currency status is earned, not given. This is not a good sign for the U.S. dollar longer-term, ensuring its decline and placing its reserve currency status in jeopardy.

As well, the possibility of China having its yuan as the reserve currency of choice among the BRICS countries or having the yuan back a new currency means that it will need more gold bullion to back its currency. China has only a fraction of the gold bullion that Europe and the U.S. currently hold, pushing China to be an active and aggressive buyer in the gold bullion market today.

Where the Market Stands; Where it’s Headed:

Last year, I made a crazy prediction that I believed stocks would start heading south on April 13, 2012. Looks like I was a few days early! Since Monday of this week, the Dow Jones Industrial Average has lost 581 points, a fall of 4.4%. In fact, yesterday was the worst day for the stock market since November of 2011.

We are getting close to the end of the bear market rally in stocks that started in March of 2009. (See: The Makings of a Classic Bear Market Trap.)

What He Said:

“Home-building in the U.S. will enter a quasi depression state in 2008 and the construction industry will make 2008 a record year for pink slips. I predict a major home builder will go bankrupt in 2008.” Michael Lombardi in PROFIT CONFIDENTIAL, January 10, 2008. WCI Communities, the largest U.S. luxury homebuilder, filed for Chapter 11 protection on August 4, 2008.

Iceland wants to adopt the dollar as its reserve currency—but it’s not the same dollar you are thinking.

Iceland suffered through a terrible financial crisis in 2008 that forced the country to make difficult decisions to get itself out of an economic mess. Thankfully, the small country has recovered and has begun to grow again.

The tiny arctic nation now wants to adopt the Canadian dollar, not the U.S. dollar, as its official reserve currency.

Even 10 years ago, dear reader, this was unheard of. Nations were beating down America’s door in order to adopt the U.S. dollar as the reserve currency that would back their local currency.

How did this change happen?

To address the credit of 2008, the U.S. government decided its response would be to print money (see: Money Printing by Any Other Name). This has led toU.S. national debt-to-GDP of over 100% and growing.

The current “official” U.S.debt is about $15.5 trillion, while U.S. GDP is expected to be about $15.0 trillion this year. Unfunded U.S. liabilities sit at about $55.0 trillion on the conservative side.

As a consequence of the U.S. becoming a highly indebted nation, Chinaand Japan, on Christmas Day 2011, decided that they were going to trade directly with each other. So, instead of converting the yuan (the Chinese currency) to U.S. dollars (the reserve currency) and then to yen (the Japanese currency), from now on Chinaand Japanare simply trading yuan to yen, skipping the use of the U.S.reserve currency.

A year earlier, in 2010, Russiaand Chinastruck a similar deal, which removed the U.S. dollar as the trading currency of choice between the two countries.

In 2000, the U.S. dollar accounted for 71.1% of all foreign exchange reserves around the world (the amount of foreign currencies owned by a country). In just 12 short years, the U.S.’s hold as the reserve currency of world countries has fallen to 61.7% of all foreign exchange reserves (source: Bank of International Settlements).

It is important to note that the U.S. dollar still holds a majority position around the world, because of its reserve currency status, but clearly the trend is declining, as more countries move away from the U.S. dollar as the world’s reserve currency.

Europe and Russia both diversified their foreign exchange reserves away from the reserve currency, and into other currencies like the Canadian dollar.

It is nothing to get alarmed about just yet, dear reader, but the trend is clearly pointing in the wrong direction forAmerica’s strong hold on the reserve currency. The U.S. dollar is the reserve currency of the world, but this privilege is not given; it’s earned.

Since our financial house is not in order because of too much debt, countries have seen fit to diversify away from the U.S. dollar as their official reserve currency. Should this continue, it has implications for higher interest rates on U.S. government debt (to attract foreign investment to buy the debt) and the loss of purchasing power for the average American consumer, as the U.S. dollar declines in value against other currencies.

One day, the U.S. could even lose its status as the world’s reserve currency. Yes, we could wake up one morning to a world where the U.S. dollar is no longer the official reserve currency.

Americans might be shocked at this possible development, but after reading the above, it wouldn’t be that much of a shock would it, dear reader? (Also see: Getting Used to Trillion-dollar Annual Deficits.)

Michael’s Personal Notes:

Out of all the possible headwinds to cause economic contraction in 2012, there is one I haven’t written about lately: oil prices.

It is estimated that, in 2011, real personal consumption—the money consumers spend on all goods and services—increased by $107 billion (source: Bloomberg).

At the same time, since October of 2011, the increase in gas prices has resulted in an extra hit to consumers’ wallets to the tune of $56.0 billion (source: Bloomberg).

Thus far in 2012, real incomes and personal spending are flat. Should these trends continue and oil prices remain at current levels, then at least half of the increase in consumer spending would be directed to paying for the higher gas prices ($56.0 billion / $107 billion = 52%).

Of course, consumers could cut back on gas consumption, but the bottom line is that if gas prices remain at current levels, GDP growth will be cut by $56.0 billion or 0.6% in 2012.

I’ve argued that two percent of last year’s GDP growth was due to inventory restocking, which will not be repeated going forward. This concept is simple to understand. If a grocer restocks his shelves fully, he won’t restock again until actual sales empty out his shelves.

So, if real GDP growth is currently at only about one percent after taking away inventory restocking, and the current rise in gas prices is taking away 0.6% of GDP growth, then we are left with 0.4% GDP growth.

This means that, if oil prices were to rise roughly $20.00 a barrel from the current $105.00 a barrel level—that is, to $125.00 a barrel—then it would wipe out the 0.4% GDP growth and just “drive” us into a recession.

These numbers are rough estimates, but they give us an idea, dear reader, of where we stand. Even if the conflict withIranwere to resolve itself tomorrow, and gas prices would drop to say $80.00 a barrel, there are still other headwinds that could drag us into a recession, as GDP growth might be nonexistent in 2012.

As of today, the conflict with Iranis at a heightened level. Despite theU.S.and other countries wanting to use sanctions and diplomacy to reach the desired goal of halting Iran’s nuclear ambitions, Israel is not waiting.

Israel has made it clear that it is growing impatient and that it will act independently of other nations if something isn’t done about Iran’s nuclear ambitions, in order to protect itself. How can the world experience GDP growth under these circumstances?

Of all the headwinds the economy faces, the persistent rise in gas prices alone could wipe out GDP growth in 2012 and lead us quickly into a recession. So watch that stock market rally and keep a close eye on gas prices—the $125.00 a barrel oil price—and Iran. They are pointing to recessionary troubles ahead.

Where the Market Stands; Where it’s Headed:

The Dow Jones Industrial Average opens this morning up 5.6% for 2012.

The bear market rally in stocks that started in March of 2009 is tired and long in the tooth. But it still has some life left to it. The stock market is not in a speculative phase as monetary policy remains very favorable, while stock market advisers are not overly bullish. I expect one more run to the upside before this rally subsides. However, for the majority of my readers, the risk in the market might outweigh the reward.

What He Said:

“Home sales down 8.4%, could be the bottom,” read the headline in last Friday’s USA Today. What do they know that I don’t? They know what realtors and their associations tell them and that’s about it. Unfortunately, the real estate news is predominately written by reporters—not real estate investors with years of experience to share. The hard facts about the real estate market in the U.S. are truly scary. How can the U.S. economy escape the hard landing in U.S. home prices? As we’ll soon find out, it simply can’t!” Michael Lombardi in PROFIT CONFIDENTIAL, January 31, 2007. While the popular media was predicting a bottoming of the real estate market in 2007, Michael was preparing his readers for worst of times ahead.

According to an independent annual audit of the Federal Housing Administration (FHA), its cash reserves have fallen so low that there is a 50% change the FHA will need a government (or should I say taxpayer) bailout in 2012.

Mortgage payments on about 600,000 home loans insured by the FHA are three or more months past due. Rising home-loan defaults amid falling home prices are responsible for bigger losses on the sale of FHA mortgage-insured foreclosures. About one-third of the home mortgages issued in the U.S. in 2010 to buy homes were insured by the FHA. (I hear the ringing—U.S. government debt going up again!)

Our government decided to take the Keynesian approach to economics (increase the U.S. government debt) and intervened in the marketplace with taxpayer money in a big way following the 2008 credit crisis. The government censured (took over) Freddie Mac and Fannie Mae…indirectly getting into the U.S. home mortgage business.

Now the next casualty could be the FHA, an agency that may have to ask for a bailout for the first time in its three-quarter-century history. And because of how the FHA is set up, it wouldn’t need to go to Congress to get approval for a government bailout; it could simply just ask the U.S. Treasury, piling more onto the U.S. government debt.

When President Obama’s first four-year term is over, the U.S. government debt will have risen 50%, or about $5.0 trillion dollars, since he first took office. There is a huge problem with this statistic.

The U.S. government debt continues to rise at an alarming rate, as the special debt-reduction committee in Congress failed to agree on government spending cuts or raising tax revenue. The U.S. government debt will continue to rise, the U.S. economy is failing to turn around, and the Federal Reserve will need to do more to bolster the economy, resulting in a continued decline in the value of the greenback and rising gold prices (see Central Banks Back Buying Gold with a Vengeance).

Michael’s Personal Notes:

I’d like to start off by wishing all my American readers a wonderful Thanksgiving weekend. Our editorial offices will be closed until Monday, when our next editorial issue of PROFIT CONFIDENTIAL will be published. Safe travels and enjoy the time with family and friends! (Did you know this year’s typical turkey dinner will cost 13% more than last year’s, according to the American Farm Bureau Federation? That’s the biggest percentage jump in 20 years! But have no fear, our government tells us that inflation is not a problem in America.)

Back in October of 2009, I wrote a scathing editorial in the pages of PROFIT CONFIDENTIAL on my dislike for Bank of America Corporation (NYSE/BAC) stock (Why I Don’t Like the Bank Stocks). Back then, Bank of America stock was trading at $17.00; today it trades at $5.37. I still don’t like the stock.

The housing bubble has cost Bank of America about $40.0 billion so far. But its problems are far from over.

Firstly, Fannie Mae wants it to buy back some loans it sold to Fannie Mae, because Fannie says the loans have defects. If Bank of America doesn’t buy back the troubled mortgages, it could face penalties.

Secondly, regulators have taken a tough stance on the bank. Regulators want more action on the part of the bank to strengthen itself. If the bank doesn’t appease the regulators, it could face enforcement action or more penalties.

Thirdly, the executive offices at the bank have become a revolving door: two CFOs, two chief risk officers, and eight new directors in two years.

Bank of America is the second largest U.S. bank in terms of lending. If the government keeps tightening the strings at Bank of America, it could ultimately end up needing to bail out the bank. The bank is putting out fires, as opposed to focusing on operations. Bank of America’s balance sheet has been shored up by selling assets as opposed to expanding profits.

The failure of Bank of America—to me, “failure” is the government bailing them out—is a possibility. It would be a catastrophe to already damaged American consumer confidence, but it could happen. At a stock price of $5.37 and falling, the market is telling us that this bank is in trouble.

Where the Market Stands; Where it’s Headed:

We are in a bear market rally in stocks that started in March of 2009. The Dow Jones Industrial Average has risen 78.5% since March 9, 2009. For the bear market rally to be over, the Dow Jones Industrial Average would have to fall decisively below the midpoint between its March 9, 2009 low of 6,440 and its May 2, 2011 high of 12,876. That midpoint would be 9,658 on the Dow Jones Industrial Average—a number we are far from.

The number of bullish stock advisors has been increasing steadily since the recent October stock market lows, while the number of bearish stock advisors has been retreating. I would feel more comfortable about stocks if this new trend in stock advisor sentiment would start to reverse.

What He Said:

“Bonds could now be a buy: Bonds rise in price when interest rates fall, as their return makes them more valuable. After a bear market in bonds that has lasted for months, the action in the bond market, as I read it, indicates that the bear market in bonds could be over. I’ve always preferred quality when buying bonds, going with government bonds over corporate bonds. If you have some cash lying around, bonds could be a great deal.” Michael Lombardi in PROFIT CONFIDENTIAL, July 24, 2006. The yield on 10-year U.S. Treasuries fell from five in the summer of 2006 to 2.4% in October 2011—doubling the price of the bonds Michael recommended.

I want to stay on the topic of third-quarter corporate earnings for the simple reason that it is earnings season and the stock market is reacting positively to the numbers. Stock market investors are still reticent to go long the market in a meaningful manner, because of the investment risk inherent in the European debt crisis. With the main stock market averages’ breakout from their recent ranges, the technical perspective is improving. We’re not out of the woods yet, but stock market trading action is getting much better.

In the Industrial Goods stock market sector, there have been some real standouts on the earnings front. This is a sector that can be heavily influenced by interest rates and trends in the U.S. dollar. The Farm and Construction Machinery sub sector in particular is benefitting tremendously from the lower U.S. dollar trend and is harboring some serious moneymaking large-cap companies, the brands of which you most certainly are familiar with.

AGCO Inc. (NYSE/AGCO) has been a stock market darling since the March 2009 low, posting a gain of approximately 200% up until the stock market’s recent correction. The Duluth, GA-based agriculture equipment manufacturer (selling brands like “Challenger,” “Fendt,” “Massey Ferguson” and “Valtra”) is booming right now, posting third-quarter earnings that beat consensus by $0.12 per share. Revenues came in above Street analyst expectations and the company guided 2011 earnings per share and revenues above current visibility. The company is saying that higher grain prices are going to drive farm equipment sales higher through to the end of the year and that higher profit margins are expected across the board.

Another well-known equipment maker, which is one of my stock market benchmark companies, is Caterpillar (NYSE/CAT). In the previous quarter, stock market investors sold the stock all the way down to $70.00 a share from $110.00 after the company reported results that were just shy of consensus (see Stock Market Leaders Under Pressure—Dividends to Become the Market’s New Best Friend). The stock wasn’t helped either by terrible stock market conditions due to weak sentiment.

In its latest quarter, however, Caterpillar’s business picked up considerably and the company reported outstanding earnings growth of 44% to $1.14 billion. Third-quarter revenues grew 41% to $15.72 billion and the company increased its full-year view.

Caterpillar is one of the few large manufacturing companies that’s hiring (5,000 alone between June and September) and the company’s business is booming in developing economies that need construction equipment. Mature economies are now going through a replacement cycle, which is also helping the bottom line.

AGCO and Caterpillar are but two large equipment manufacturers that no doubt contributed to the surprise gain in the non-auto/aircraft portion of durable goods orders in September. The latest data showed a marked demand increase for computers, primary metals, fabricated metals, heavy machinery, and electrical equipment. All these industries are benefitting from interest rates that are low and a weaker U.S. dollar.

Both these companies make great products that are benefiting from a strong business cycle in agriculture, construction and mining on a global basis. A weaker U.S. dollar against a basket of world currencies is certainly helping the bottom line, but, on balance, I view these businesses as doing very well on their own.

Since June of last year, the U.S. dollar index (a measure of the value of the U.S. dollar versus a basket of foreign currencies) has been in a marked downtrend, fostered by a monetary policy of reduced interest rates and rising money supply. This is helping U.S. large-caps that have major international businesses and it’s contributing to the earnings outperformance with many of these companies. It’s pretty clear in my mind that a weaker U.S. dollar as a policy is helping corporations and that stock market investors should see some significant dividend increases in 2012. The primary U.S. dollar trend has been recently put on hold by the debt crisis in Europe, but once this is dealt with (hopefully sooner rather than later). I expect the U.S. dollar to resume its weakness, which will help domestic gross domestic product (GDP).

The stock market now has some positive momentum, which I think can produce a decent gain before the end of the year. In my view, monetary stimulus is beginning to work and a generally weaker U.S. dollar is being very helpful. I have no problem with the U.S. dollar continuing in a downward trend, as this will go a long way towards helping the manufacturing and export sectors, as well as stock market investors who have been sitting on the sidelines in an otherwise lackluster market.

It’s great to see big, brand-name U.S. corporations reporting great numbers. It’s a trend that I think will continue going into 2012, as long as interest rates and the U.S. dollar stay low. I hate to admit it, but Federal Reserve policy on the U.S. dollar seems to be working.