It’s called carry, but not like currency carry. As most know, banks can fund themselves at 0.1%-0.25% as the Federal Reserve keeps Fed Funds at 0.0%-0.25%. Then banks are incentivized to find the safest, highest return they can with this cash.

Now, the US Treasury and the Federal Reserve hope that this low cost of funding to banks would make lending more attractive and incent banks to make new loans. As the Fed loan surveys show, this is now occurring and new lending is not being generated. This is a phenomenon that is not only occurring in the United States, but also in the UK as there loan surveys show the same drop in loan volume.

This is not that surprising given that banks continue to have to set aside loan loss reserves for commercial real estate and loan defaults by small and medium-sized U.S. businesses rose in September to 0.85% from 0.81% in August. This means that while the US economy is improving that banks are still facing headwinds with previous loans that were made during the last 3 years.

Then where is this cheap money going? Why back to the US Treasury! Banks earn a somewhat risk free return on their cheap money from the Fed by purchasing US Treasury securities. Depending on where they buy on the yield curve, they may earn 30 bps for 1yr, 75 bp for 2 years, and a whopping 210 bp for 5 years. They fund these positions by borrowing from the Fed at 0.1-0.25%.

But there’s one more big incentive for banks to do this carry trade. If they buy something other than Treasury securities, they have to set aside a percentage of the assets value based on the risk weighted asset rating. This carry is only limited by what regulators will allow the bank’s leverage ratios to reach.

As a matter of fact, this carry situation is exacerbated by regulators telling banks to increase their tier one capital ratios. You can do this by either adding capital by issuing shares or generating profits/retained earnings, or by bringing your risk weighted assets down – the most RWA consuming assets generally are loans. Guess what is the easiest for banks to do?

As the world looks to see how the massive US Treasury auctions are going, don’t be fooled into thinking that the US government can easily fund itself because the markets have confidence in defect reduction down the road. As the economy recovers and the business environment shifts, this bank-Treasury carry trade incentive will be reduced as the Fed raises interest rates and the cost of funding the carry goes up.

Therefore, the appetite for US government securities will be reduced as well and we’ll get a much better view of how the world feels about the US massive fiscal deficits.

Bloomberg carries an interesting analysis of the looming shift of US Treasury issuance for 2010. “After selling $1.9 trillion of short-term securities to finance President Barack Obama’s efforts to end the worst recession since the 1930s, the Treasury plans to lengthen the average due date of its outstanding debt to 72 months from a 26- year low of 49 months. That may mean boosting sales of 10- and 30-year bonds by 40 percent over the next year to $600 billion…”.

As everyone knows, this week ends the Federal Reserve’s $300 billion QE program of monetizing the US government debt by purchasing US Treasury securities. (BTW, Congress has to increase the debt limit very soon and this will be jacking newsflow on this subject.) The US Treasury is going to auction this week $123 billion in new note debt this week alone. After the Fed stops their MBS QE program at the end of Q1, we’ll see a how interest rates respond without the Fed distorting it.

The point is that the US Treasury is going to increase duration as the same time that the Fed is dropping their QE programs. This should translate into a steeper yield curve and higher cost of funding the US government…….which means more borrowing to fund the deficit which means more issuance which means more borrowing to………

As US corporations continue to report better than expected earnings for Q3, it’s hard not to be upbeat and positive on the outlook for the stock market. Honeywell, Amazon, Kia Motors, and Microsoft all beat expectations as 77% of companies in the MSCI World group have exceeded projections. The reasons for this outperformance are multifactoral from extreme cost cutting via job losses to an improved revenue stream. On CNBC’s Earnings Central page, 15 out of 17 companies reporting in the last 24 hours beat expectations.

Money appears to keep flowing back into equities and the rally continues to extend. However, I believe there’s more at work than meets the eye. From the research I did for my book, World Event Trading, the one over arching investment rule for equities over time is this: buy when the central bank is easing. It’s not perfect, but it works.

As most know, the Chinese have done what most around the world wish they could do. They have “encouraged” their banks to lend and lend the banks have. The Chinese had targeted 5 trillion renminbi of loan volumes and by the end of July over 7 trillion in loans have been provided. This is high powered, high velocity money. This lending has spilled out into all areas of the economy and has bled into the equity markets as well. Some research has estimated that as much as 20% has ended up buying stocks. Anecdotal evidence of pig farmers hoarding copper has shown up as well.

This leads me to contemplate that something similar may be occurring in the United States and the UK. The QE programs have essentially printed money and put it into the banking system. Unfortunately, this money is not high velocity as it has sat on the bank’s balance sheets. The loan surveys for the UK, US, and some bank earnings reports have shown a drop in demand/volume of loans. However, we know that Goldman and Morgan Stanley reported large earnings due to trading. Is this related to cheap funds provided by the Fed?

More importantly, does it matter why stocks are going up as long as they go up? Not really, but we may be missing the trade here. Unlike China, velocity has remained subdued in the United States. If this were to change, then we could experience a similar market reaction as China did this year as money spills into speculation. This is not a market call for the next 5 minutes, but one for the next 12 months until the Fed tightens. It may help explain why stocks have not had a major pullback.

Granted, the Chinese are expecting to see inflation jump to 5%, but this is the price the Chinese are willing to pay to jack up the economy. Will the Fed be willing to do the same thing? With the US dollar under attack, the answer appears to be yes.

Here’s a quick back of the envelope list of countries and whether the currency’s strength will be a problem to engage in reducing monetary stimulus.

1. Australia: no problem
2. New Zealand: no problem
3. Canada: a problem
4. Brazil: a problem
5. China: no problem
6. UK: no problem
7. EZ: no problem
8. US: no problem……but no exit.

Brazil and Canada are clearly the poster children for currency strength duress as both those nations made it clear they are not happy with the situation yesterday. After the government denied on Friday then announced on Monday a tax on foreign investment, the US dollar shot up 350 points or about 2% ag the real. Also yesterday, the Bank of Canada specifically mentions the strength of the Canadian dollar as an inhibitor of growth and interest rate hikes. The US dollar rises about 350 points or 3.5% against the loonie.

This brief respite for the US dollar is most welcome for our trade partners. However, it’s likely to be fleeting if no other changes occur. The US fiscal deficit remains the major concern for US dollar reserve holders and the situation is not improving. Granted, the peak of new Treasury issuance occurred in August. However, there is no sign from Washington that spending will be under control any time soon.

This is why you have seen this week US Treasury Secretary Geithner and Federal Reserve Chairman Ben Bernanke all warn that the US fiscal deficit must come down or risk disaster. They know that the US dollar is weakening due to this red ink. 2009 fiscal deficit was an astounding $1.4 trillion as spending increased from $3.0 trillion to $3.5 trillion while tax revenue fell from $2.5 trillion to $2.1 trillion. The debt is now at $12 trillion and is expected to grow by another $9 trillion over the next decade.

Without any changes to health care, the CBO estimates spending for Medicaid and Medicare is expected to grow $700 billion over the next decade. With health care legislation conservatively estimated to add another $900 billion to the deficit, the numbers are spiraling out of control. Actually that phrase doesn’t do the situation justice. Maybe the trailer for the movie 2012 is more appropriate.

Most disturbing is the combined level of federal, state, and local government spending. According to the OECD, this totals up to 42% of U.S. gross domestic product. Think about it: 4 out of every 10 dollars of everything produce in this country is channeled through governments. Quick poll: who thinks this is the most efficient way to run an economy?

The point is that the US has embarked on a glide path of spending that is making the currency weak and US dollar reserve holders knees weak, too. The Federal Reserve appears to be the only one left in the government who can do something about it by raising rates. With unemployment expected to continue upwards, this is not expected to happen soon.

This means that in the short term, the only change to the downward direction for the US dollar has to come from outside the country. So far, Brazil and Canada have acted. In the long term, the US has to act to change spending or rates. Unfortunately, Congress is likely to actually increase spending while the Federal Reserve is unlikely to raise rates.

Therefore, the US dollar is likely to remain weak for a long period of time.

In the past, consumer spending was 70% of the US economy. In the past, an increase in consumer confidence has led to an increase in consumer spending. We have seen global increases in consumer confidence including today’s UK numbers. US consumer confidence has risen from a low of 25.3 in February to 53.1 in September. However, retail sales are still lagging and are expected to be down 2.0% in September.

According to the Discover US Spending Monitor, US consumers are still worried about their personal finances and are limiting their spending plans. The survey showed 19% expect to spend more in the next 30 days, down one point from August; 54% said they planned on spending the same amount, up two points according to Dow Jones. “There appears to be no indication consumers are willing to increase their spending, despite a Monitor-high number of them who feel the economy is getting better,” said Julie Loeger, senior vice president of brand and product development for Discover.”

This is why predictions of holiday spending are for either flat to a meager 1.0% increase. This is also why predictions for Q4 growth are tepid and lower than Q3. This also explains why Federal Reserve members give speeches that are consistently dovish and consistently say they will stay on hold for a long time.

Today in a somewhat surprise move, the Reserve Bank of Australia raised interest rates 25 basis points to 3.25%. The RBA becomes the first G20 central bank to officially begin an exit strategy from monetary easing to stem the global financial crisis. They had previously cut rates a record 425 basis points. RBA Governor Stevens said, “The risk of serious economic contraction has passed.”

Australia didn’t experience a contraction to the extent that Western countries have and is fortunately tied to economic stimulus in China. However, this tie comes at a cost as the massive Chinese loan stimulus has bled out to commodities, stocks, and real estate. In August, Australia saw retail sales, building approvals, mortgage lending, and property all increase significantly. Home prices have risen almost 8% this year. The one statistic that has not improved: unemployment. Its expected to rise to 6.0% in September from 5.8% in August.

The RBA raising interest rates now underscores their belief that their monetary policy is excessive and needs to be pulled back even before a lagging indicator like unemployment responds. This will bolster the market’s confidence in the central bank and it’s independence from the government. The Australian dollar has been bolstered as well as the market’s react to a hawkish stance on potential inflation.

As the G20 world points fingers at the US for it’s weak dollar policy, the Obama administration and Federal Reserve should take notice. It’s not the specifics of a new world reserve currency or the specifics of pricing oil in non-dollar terms, it’s the fact that it’s being discussed that matters! The rest of the world is greatly and gravely concerned not only of the current US dollar decline, but also of the potential bigger decline yet to come.

Due to the extraordinary financial crisis and monetary response, the Federal Reserve can take action. The Board should do something extraordinary to deal with the US dollar fallout. If the Fed wants to stabilize the greenback, it should raise rates like Australia before unemployment peaks. This would stabilize the US dollar and and make a strong statement about it’s independence. It needs to do both.

After the Pittsburgh summit, we found out that the major group economic decisions by large industrialized nations will be made within the G20 framework. This deflated expectations for last weekend’s G7 meeting in Istanbul. This smaller group may shrink further as the US has proposed a Seinfeld-like G4 of US, Japan, Europe, and China. Remember, one year ago the G7 issued an agenda to resolved the panic that was occurring in the financial markets.

At the meeting this year, there were the obligatory comments from Geithner that the US would do everything we can to sustain a strong, stable dollar including cutting the budget deficit after this crisis has passed. (So I’m confused, are we still in the crisis then?) Also, we had the new Japanese Fin Min Fujii say, “If currencies show some excessive moves in a biased direction, we will take action.” From Canada, Bank of Canada Governor Mark Carney say that the central bank is “not closing off any options” on the Canadian dollar exchange rate in order to meet its inflation target according to MNI. Carney acknowledged that Canada’s dollar (strength) is presently a major risk in meeting it.

Even still, the 2009 G7 Finance Ministers statement said, “We welcome China’s continued commitment to move to a more flexible exchange rate, which should lead to continued appreciation of the Renminbi in effective terms and help promote more balanced growth in China and in the world economy.” the IMF has stated that the G7 urged China to allow their currency to strengthen. One official went as far to say that one day the Chinese yuan will rise and that the Istanbul meeting will be seen as the new Plaza Accord. Apparently, ambition was not killed off at these meetings.

ECB President Trichet said that the need to rebalance the global economy does not at all mean the US dollar should depreciate against the euro. But he did support what the IMF official said. “It is absolutely clear that a number of currencies have to progressively and orderly appreciate vis a vis both the dollar and the euro, but certainly not at all any change in the bilateral relationship,” Trichet said. “If there is any qualification, it would certainly be that the other currencies, in particular currencies of the emerging world, should appreciate, or would appreciate, taking into account this strategy in the medium and longer term.”

The spotlight on China and other EM countries will not force them to act however. China is not likely to go along with a stronger currency until they can feel confident their domestic demand will pick up the slack for the loss in exports that will come from a stronger currency. To stimulate stronger domestic demand, the Chinese government will need to get their savers to spend more. To do this, major changes need to take place to provide assistance for education, health care, and retirement to get savers to turn into spenders. This will take time.

In sum, the G7 finance ministers issue promises and threats on currencies with no collective action. They change nothing except their size. And maybe, that’s the best thing we can hope for from them.