A year or so ago, I wrote a piece discussing that when the world credit bubble (pan financial bubble in markets and assets) unwinds, world governments will be forced to try and support the markets. The prediction was that this will amount to monetization of failing markets. The alternative to monetization would be intolerable financial panics and market collapses, where people lose all their savings. (Monetization is where central banks buy assets to shore them up, thus using the currency to support collapsing markets. This is in the process of happening now in the EU and the US.)

Right now, we are looking at the precipice of a total world financial collapse. When the stock markets finally let go, people will wake up to the reality of world financial bankruptcy. Millions of people will lose much of their retirement savings, in a super world stock crash, and you will again see stories about people refusing to open their 401k statements because they don't want to see how far down they are. That's what happened right after the Tech crash. Well, think of that episode as merely a taste of what is to come.

I am not exaggerating. To date, the US and EU central banks have put up an astounding $2.5 trillion worth of money to their respective banks and bond markets. They are doing this to prevent a total banking collapse. So far, they are barely staving off a massive wave of bank failures world wide, but particularly in the US and the EU region.

Unfortunately, the ones really on the hook for all this coming market collapse will be the big retirement funds, as they are the ones invested in all these bubbly world asset and financial markets. That shoe will drop.

Bond and securitized debt chaos

We are not going to detail the many stories about how the bond and credit markets are collapsing. But, suffice it to say that many huge credit markets are literally frozen. Whether it's the mortgage derivative securities, a $3 trillion plus market, or the US GSE markets, something like $ 7 trillion in size (this is Fannie and Freddie and such), or municipal bond markets, $10 or more trillion, and if you can believe this, or even the US treasury secondary market (already existing US T bonds that are sold between investors), these credit markets are freezing up in a big way.

Securitized debt markets new

Just to make a comment on this, the securitized debt market is fairly new. This is where large investors bought big packages of mortgages, or whatever kind of debt you can imagine like credit cards or student loans, that were securitized and sold off. There are many types of these, like CDOs, MBS, SIVs, etc. (CDO – Collateralized Debt Obligations, MBS – Mortgage Backed Securities, SIVs – Structured Investment Vehicles).

This type of lending became a standard in the last ten years, and has effectively absorbed the entire world lending market for everything from corporate bonds to municipal bonds to credit cards to mortgages.

Being a new and very complicated market, and utterly gigantic, the treasuries and central banks have stated that they don't understand them well enough to try and solve all the problems. The Fed, the ECB, and the BIS have all commented that they don't understand this new securitized world debt market that has taken over all credit worldwide. This is not a good thing – to put it mildly.

What I am trying to say is that this entire new, huge, world credit apparatus is now imploding. There is no need to detail the many examples, as the press has been full of article after article about these specifics.

What is going to happen next?

The point of this article is to briefly examine how I expect the financial markets to react, what is going to happen next, and how the central banks are going to react. Gold figures here in a big way as well.

Proper way to view the gold market

First of all, I would like to give people a very general way of looking at the gold markets right now. If I were to put speculation in gold aside for a moment, I personally view the entire world gold stock – jewelry, bullion, and central bank gold, as a counterweight to the world's entire stocks of currency. That is a great way to get a feel for what is happening with gold right now. This also works for looking at each separate currency, whether it's the Yen, Euro, or USD.

For purposes of discussion, if we were to say that gold has risen by roughly 50% in USD in the last year, it might be said that the gold market's opinion of the USD has fallen by that percent, ie there is now 50% less confidence in the USD, so gold's USD price rose that much.

Now, this may sound obvious, but this 'counterweight to currency' is the way people need to look at gold. I don't prefer to use the 'investment' concept to look at gold. I like to use the valuation aspect of it – ie its verdict on currency value.

I mean, obviously, if you look at gold rising 50% in price terms, then that's a great gain. But if things are collapsing financially, and prices are rising dramatically, then that so called gain is offset quite a bit. To look at gold as valuing the currencies is a better way to view gold than using the 'investment' theme. One should not think about gold primarily as an 'investment'. It should be thought about as cash – the one cash in the world that everyone will take, no questions, and is a counterweight to the world's other cash – the various currencies outstanding.

What is gold telling us about central banks actions since August?

This gets us to the second part of this discussion. What is gold telling us about the way central banks are handling the credit crisis that exploded in August?

Well, if you look at the gold price chart since August, it clearly indicates gold has risen dramatically just as the credit crisis exploded. I know, I already posted this chart, but take a look again:

As the credit crisis expands, gold has risen in direct correlation. Why is that?

Gold says central banks are failing this time

Gold has risen in tandem with the credit crisis because the central banks are falling behind the world credit deleveraging since August. If the gold markets felt that the central banks had a handle on the credit crisis and world financial meltdown, ie that cutting rates would work to stop financial deleveraging and economic contraction, then gold would not rise as much.

This time, gold is clearly giving a verdict that Central Banks are failing to reflate a massive world deleveraging, that markets are going to unwind no matter what the CBs attempt to do.

If central banks fail to reflate credit and financial markets, then the only alternative for world governments is big deficits. More programs to bail out banks, more central bank $trillions to try to stem the losses. Effectively, more debasement of world currencies.

If central banks could succeed in stopping the world deleveraging, and stop the massive financial hemorrhaging on every consumer's balance sheet, every financial institution's balance sheets, then gold would not rise as much as it has. If gold expected things to normalize, and gold expected that central banks could escape outright monetization of problem markets this time, gold would not be rising as much as it is now. Gold is up 50% since August, when the credit crisis and world deleveraging began.

Clearly, gold has decided that central banks have lost control of the situation, and the only alternative is more interest rate cuts, which makes borrowing cheaper and is economically stimulative, but lowers the value of currencies. On top of interest rate cuts, central banks are now doing outright bailouts, which also devalue currencies. Outright bailouts are monetization.

'Counterweight to currency' view of gold

Of course, there is a lot of speculative action in commodities and gold. A lot of the thinking about gold is related to speculation activities and trends. But, I think it's easier and better to look at gold prices right now in the context of its role as a counterweight to the world's currencies. Gold has risen 50% since August primarily due to the expectation that central banks are going to try and monetize collapsing financial markets, and bail out many financial institutions.

The investing and speculation aspects of the gold market are not the primary driver of the gold price right now. This would explain why gold has not corrected much since August, but rather relentlessly risen. There are a lot of profits in gold right now, but gold has not corrected significantly for a long time now. It is rising due to currency devaluation expectations as central banks fight the relentless credit and market deleveraging. They are failing, thus more expectations of central banks using their currencies to fight the deleveraging going forward. So, the gold price continues to rise and keep its gains.

World economy credit driven

The trouble is, none of these central bank efforts seem to be working. New big credit markets are freezing up each week. The already frozen ones are not recovering either. Given the fact that our world economy is primarily credit driven, what do you think that means for the next several years for the world economy? I'll let you answer that yourself.

What is happening in general is that financial and asset markets are deleveraging. The general world economic situation can be regarded this way, as deleveraging, and it won't be a bad oversimplification. All this borrowing that went into bidding up world financial and asset markets is now going to be unwound. I read a banker's comment around September that 'The credit unwinding will not be denied.'

That appears to be exactly what is happening.

USD, Yen, Euro, gold

If you agree with this, then what is the prognosis going forward for the Yen, Euro, and USD? And thusly for gold?

In a nutshell, the central banks will attempt to stop the deleveraging. They have failed so far, and will continue to fail. As the economic contraction worldwide gets more and more painful, they will make more big efforts to stop the deleveraging that 'will not be denied.'

At some point, I expect one of the central banks among the ECB or BOJ to give up on the reflation efforts (to counteract the deleveraging.) At some point, they will realize that the efforts to stop the deleveraging is futile, and only adding to public debt, and just making things worse.

At that point, everything just finishes unwinding rapidly. It will be very very scary for everyone and every country. The implications are really rather staggering.

Which is why the central banks are fighting this deleveraging as hard as they are now. In fact, the Fed would have cut interest rates faster, but they risk cutting the ground from the USD. Their hands are tied to a significant degree.

The ECB will be forced to cut this year, otherwise the Euro continues its painful strengthening. The Fed has basically no choice but to continue cutting. The alternative would be collapsing stock markets. That will likely happen anyway.

Maxed out this time

Basically, the only solution to massive unwinding of credit, theoretically, is to get borrowing and economic activity to start growing again. That way, world consumers would then start buying everything and, if the economies recover, then the present leverage out now can be carried forward.

But that is not happening, is it?

Why is it not happening? Why are lower interest rates failing to restart things? Because, this time, unlike 2001, people cannot borrow any more. They have already borrowed all they can. This time, cutting interest rates will not work to revive economies. The only other option is government spending, and or using currencies to stimulate things. Using currencies to keep things going will fail because the deleveraging worldwide is way too vast.

If cutting interest rates will not work to revive economies this time, then the deleveraging will continue relentlessly. It is that simple.

And, why are the bond markets freezing, and such? Because lenders of all types, who bought all the securitized debt, now realize that the present levels of debt in every sector, public and private, cannot be kept up. So, then, why do new lending? Everybody is maxed out. The reason for the collapse of the credit markets is also that simple.

The only thing standing in the way of a total world financial collapse right now is all this massive emergency lending by central banks to financial institutions. That means that, when enough big investors realize there will be no economic recovery from cutting interest rates this time, the stock markets will finally collapse big. I expect this to happen sometime this year, election or no election. The problems are just too big.