Things are not getting better. In today’s Wall Street Journal we see that US payrolls shrank dramatically, recession fears are weighing on the stock market, Carlyle Capital, a unit of Carlyle Group, is unable to meet margin calls on its $21 billion portfolio, the number of US houses entering foreclosure hit a new record, homeowners’ equity in their homes is falling to new lows, Jefferson County in Alabama is refusing to pay a margin call on a derivative trade that went bad, Washington Mutual and other lenders are begging sovereign wealth funds for money,... the list goes on but I’m tired of quoting headlines. This was all just on the front page of today’s online WSJ. What will tomorrow bring?

That, of course, is what is more important: what will tomorrow bring? It doesn’t help fretting and complaining about what is happening right now, we have to act and prepare for what is to come. Unfortunately, nobody can predict the future; but we can read the signs and form an opinion of what might happen.

We know from the work that John Williams (www.shadowstats.com) is doing that money supply in the United States as measured by M3 grew at an annual rate of more than 16% during February. That is the highest level of monetary inflation in the history of the United States -- it’s a higher rate of inflation than during the 1970s.

As a result of the inflation during the 1970s US interest rates soared. In January 1970 the yield on a ten-year US Treasury bond was just under 8%. By January 1980 the interest rate had increased to over 10% and in October 1981 peaked at over 15%.

For comparison, the year-over-year increase in M3 in January 1970 was only 1% (that is not a typo). By January 1980 the year-over-year increase in M3 had reached 10%. Let’s recall that the 10-year interest rate in January 1970 was 8% and by January 1980 it had increased to 10%. Today, the annual increase in M3 is running in excess of 16% and yet the yield on a ten-year Treasury is only 3.78%.

One thing is certain: interest rates in the US are going to rise very significantly. A rise in interest rates means a decline in bond prices so I would not touch bonds with a barge pole over a broken telephone line.

The Federal Reserve sets the Overnight Rate and the Discount Rate, both of which have declined recently and both of which are likely to continue to decline. But the market sets all the other interest rates and it won’t take long now for the market to figure out that buying ten-year US Treasuries with a yield of 3.78% while monetary inflation is running at over 16% is felony stupid.

In response to the credit crisis the Federal Reserve created its Term Auction Facility (TAF) in December by which it would loan banks money on collateral that up until then would not have qualified for a loan. TAF also increased the term of Federal Reserve loans from the typical one day to twenty eight-eight days. Both of these were major concessions in the face of a crisis and both are properly categorized as emergency responses. The first TAF auction occurred on Monday, December 17th, and was for $20 billion. On that Monday the banks asked for over $61 billion but the Fed only released $20 billion. Today the Fed announced that TAF auction limits will now increase to $50 billion. The Fed also announced today that it will initiate a series of repurchase agreements with banks that are expected to amount to $100 billion.

Why is the Federal Reserve pumping cash into bank balance sheets? Because the banks are in dire straits. In November last year the banks borrowed 0.85% of their reserve requirements from the Fed. In December they had to borrow 36% of their reserve requirements and by January they were borrowing more than 100% of their reserve requirements.

Now, many people seem to think that because the banks are borrowing more than their reserve requirements from the Fed through its new TAF we should not be concerned. They reason that the Fed is making the money available on reasonable terms, so why not? They neglect to recall that TAF only exists because there is a crisis: the banks can not meet their reserve requirements.

The idea that borrowing through TAF is merely opportunistic and not driven by necessity is ridiculous. At the end of January required reserves were approximately $40 billion but banks borrowed $49 billion from the Fed. They used $40 billion to meet their reserves and left and extra $1.4 billion in their reserve accounts, which means the banks were using TAF to fund other operations to the tune of approximately $7.5 billion.

By February 27th, the banks were borrowing $58 billion from the Fed. Reserve requirements were about $41 billion and excess reserves were $1.8 billion, meaning they were now using $15 billion for other operations. Look at the pattern: In December borrowing from the Fed, including TAF, was only to meet their reserve requirements. By the end of January the banks borrowed an extra $6.5 billion and in February an extra $15 billion. Obviously there is trouble afoot.

Remember that TAF is an emergency measure created by the Fed to alleviate the stress in the banking sector as a result of the meltdown in credit markets. $15 billion of emergency borrowing through TAF over and above their reserve requirements should not be dismissed as insignificant. It is a clear indication that the banking crisis is worsening. Last week I mentioned that the FDIC is gearing up for bank failures in the US -- it’s just a matter of time.

Personally I have bought, and will continue to buy physical gold instead of keeping my cash in dollars, or any other fiat currency. But I want to stress that I am not making a short-term call on the gold price by doing so. This is cash that I intend to keep for a very long time: I think it’s going to take a long time to untangle the mess we’re in.

The gold price is up almost 50% in six months. Nothing goes straight up and so I would not at all be surprised to see the gold price fall $150 or more in a short period of time. This is not a prediction, since I think it could equally easily increase $150 or more. What I am trying to do is suggest that you make sure you can handle that kind of volatility before you step too deep into the pool.

While I was editing this letter a friend sent me an email asking: “How does the world look?” I was still working on the letter and didn’t want to think too much about the question so I just shot off a reply saying that something big is going to happen sometime soon and I don’t know what, or where, but too much is unraveling too fast.

Afterwards I found myself thinking that that subconscious response was exactly how I felt, and perhaps I should mention that to you as well.