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Denying Economic Reality

Many people tend to live big parts of their lives in denial. As an example a man can stay with a dissatisfying job for years, telling himself that he doesn't have the proper education or the right skills to get a satisfying job. So instead of getting the right skills he keeps denying his capabilities to avoid the effort needed to give him the job of his dreams.

This type of denying behaviour can be found in many areas of life because people are either too lazy or too complacent to take the necessary actions to improve their lives. For a single individual to live in a state of denial is one thing. For a whole world to be in a state of economic denial is another story and can have disastrous consequences to the world economy.

The US economy has been driving the world economy for the last 20 years. The expansion started in the early eighties after a 16-year long bear market. The outcome after 20 years of prosperity are a corporate and consumer sector that is drowning in an ocean of debt.

What should be very evident is the fact that this prosperity has been created by debt. What the world refuses to see is that in the "real" world, debt has to be repaid. You cannot ad debt on debt forever. Eventually the economy gets debt saturated usually with very low interest rates. At that point the expansion stops and then reverse. That is where we are today. The expansion has stopped and is now beginning to reverse.

The long-term deterioration of economic fundamentals (and as of Feb-May also the technical picture) is so evident that you have to be in a state of denial not to see it. An enormous load of debt in both corporate and public sector is causing records of bankruptcy and foreclosure. High commodity prices will eventually lead to inflation pushing up interest rates. Oil prices exceeding 40 dollars per barrel will raise the price of almost everything manufactured adding more inflation and even higher interest rates. The US trade and budget deficits are setting new records everyday increasing world imbalance even further. There have been almost no jobs created whatsoever since the US recession ended in 2001 and in response minimal salary increases for workers. Interest rates have been on the rise since July 2003 and are now marching higher at rapid pace again.

The financial markets still ignore the magnitude of inflation approaching and the higher interest rates that always follow, the markets will probably be shocked when this storm arrives in full, and a bond market crash seems inevitable. Ironically, all the FED induced inflation and the resulting bond market crash will swiftly lead to deflation. Higher interest rates will create a panic for dollars to repay the huge consumer debt load. Consumers will have to cut back on spending and demand will drop.

Economic denial has been going on for years now. When market participants collectively realize they are positioned on the wrong side of the market everyone will want to sell at the same time probably causing a panic. Liquidity will dry up and cause huge price gaps as the markets come crashing down. The long lasting denial of market participants has created a perfect set up for a stock market crash of disastrous proportions. When a person in denial is confronted with a reality that is a lot worse than the one imagined the normal reaction is shock and panic. The financial markets will react in the same way when reality suddenly shows its ugly face.

Summary: The financial markets are still denying the fast approaching storm of inflation and the rising interest rates that follow. To quench the coming inflation history suggests yields on the US 10-year bond will soar to the 8-10% range. Stock markets will crash in response and record new lows. The US economy will experience a severe debt deflation and eventually develop into a new depression...

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