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Europe's Anchor-Shaped Bombshell

Can the ECB control global inflation, Gold, oil and even Fed policy with a July interest-rate rise...?

FINALLY IN JUNE, European central bankers couldn't hold back their deep frustration with the Bernanke Fed's denial of commodity-price inflation any longer, notes Gary Dorsch of Global Money Trends.

   The European Central Bank delivered its first bombshell to the market in 12 months at the start of this month.

   "After carefully examining the situation, we could decide to move our rates a small amount in our next meeting, in order to secure the solid anchoring of inflation expectations," warned ECB chief Jean-Claude Trichet on June 5th.

   Those words – "anchoring inflation expectations" – were simply the ECB's code for a baby-step quarter-point interest rate hike to 4.25% in July.

   Once again, however, "Tricky" Trichet managed to bamboozle market traders.

   "The ECB is not split, we have sent a clear message to the markets about what to expect in the near future," said Trichet's sidekick, Bundesbank chief Axel Weber, also on June 5th.

   "We have to let deeds follow words."

   The ECB's shift towards a tighter money stance ricocheted across the world, sending bond yields surging in the UK, Canada, Germany, and the United States. In Japan, bond prices plunged to their lowest level in nine months as open-market interest rates jumped.

   Up until the European Central Bank delivered its bombshell, the ECB was widely expected to follow in the footsteps of the Anglo-Saxon central banks, cutting its key interest rates to cushion the downfall of the European banking sector.

   So far, global banks have recognized $350 billion of losses from toxic sub-prime US mortgage debt. The Swiss National Bank says the write-offs are only half-way over.

Taking aim at the easy-money clique within the "Group of Seven" cartel, Bundesbank chief Weber argued on June 6th that "Central banks should not cut interest rates in order to help banks with their refinancing needs, but instead, should keep monetary policy focused on maintaining price stability."

   Italian central banker Mario Draghi then said G-7 central banks should take some of the blame for the current inflation spiral, because of "monetary policies that favor excessive money and credit growth globally, with exceptionally low interest rates."

   In its battle of tough words, the ECB had already stood steadfast against German bund traders, who had driven benchmark two-year Schatz yields as low as 3% in mid-March. They were betting on a series of three ECB rate cuts to 3.25%, to bail-out bludgeoned speculators in the Eurozone stock markets.

   But the ECB refused to be bullied by Schatz traders into an easier money policy, unlike other G-7 central bankers – notably Bank of England chief Mervyn King – who lost their nerve.

   Back on February 1st, Greek central banker Nicholas Garganas said, "Our monetary policy is not led on what the markets expect. I'm very concerned about the high inflation rate.

   "Inflation risks remain on the upside. If there's a risk that we'll not achieve our objective in the medium term, we'll act pre-emptively and decisively."

   Yet the ECB waited for crude oil to soar above $125 per barrel, before signaling a baby-step rate hike, out of fear of sending the Euro through the roof vs. the fast-weakening Dollar. German Schatz traders were then rocked by Trichet's bombshell last week, with the two-year yield soaring as high as 4.80%, its highest in seven years.

   However, this highly leveraged and volatile market tends to overshoot when the herd mentality kicks in. The sudden leap in Eurozone bond yields prompted Bundesbank hawk Juergen Stark to publicly state that the ECB is not planning a series of interest-rate hikes – and his equivocation knocked the two-year German yield back to 4.53% a week after Trichet spoke.

When the dust began to settle down, it became clear that the ECB was calling "Bernanke's Bluff" on defending the US Dollar.

   Seizing upon Bernanke's vow to the International Monetary Conference (IMF) that he's working to defend the Dollar, the ECB is now testing the true intentions of the Fed, by signaling a pre-emptive interest rate hike to 4.25%. That will only widen further the German interest-rate advantage over current US Treasury bond yields.

   The Bernanke Fed's new search for anti-inflation credibility has already been badly mutilated, both by the weak US Dollar and the fireworks display in the commodities markets. It will take much more than a few sentences from Bernanke to undo this damage.

   Now the ECB has called "Bernanke's Bluff" it leaves the Fed chief with little wriggle room other than to defend the Dollar with higher US interest rates. The ECB is forcing the Bernanke Fed to stiffen its spine, in short, and narrow the gap between higher yielding German notes and lower yielding US debt.

   Lifting the Fed funds rate is the only way Bernanke can make good on its pledge to defend the Dollar.

   In the past, European central bankers tended to follow the US Federal Reserve in setting interest rates.

   This time however, while the Fed slashed rates 325 basis points, the Europeans refused to follow. Now the ECB will likely move in the opposite direction with a baby-step rate hike. This suggests that in terms of global monetary policy, we're witnessing a historic shift in the balance of power.

   If the ECB can now dictate policy to the Fed, then it's another sign of America's loss of global hegemony. And taking the lead among the G-7 central banks in stopping the march of inflation, the ECB has also engineered a sharp decline in the Gold Market. For German and French investors, the price of Gold has tumbled to €556 per ounce from a record high of €640 three months ago.

   Central bankers in Brazil, China, India, and South Africa have already tightened their monetary policies in recent months, hiking interest rates to combat inflation. But the Fed appears to be hand-cuffed by a weakening economy.

   The problem is that, if Bernanke is bluffing about a tighter money policy to defend the Dollar, he will open a Pandora's Box of greater instability in the global commodity and money markets. Failing to act against US inflation – not least with the ECB clearly breaking ranks – would re-ignite the bull market in Gold. And it will take much more than a baby-step rate hike or two, even at the European Central Bank, to contain the "Commodity Super Cycle".

   The Bernanke Fed has contributed greatly to the surge in global inflation, by pegging the Fed funds interest rate deep into negative territory after the rise in consumer-price inflation, and neglecting the Dollar's loss of value. But the ECB's power-play isn't without risks.

   Aimed at forcing the Fed into a partial reversal of its rate cuts, a possible European interest-rate hike in July would come at a time when German factory orders have declined for five straight months. So it carries the risk of weakening the European and global economy.

   Adding to the tension, crude oil prices are perched above $125 per barrel, a tipping point that could derail the global economy into a wreck. Yet the alternative, a march into the abyss of hyper-inflation, could lead to even greater turbulence and an economic depression.

   Whether the ECB can pull-off this magic trick, and prod Bernanke and his boss – Treasury chief Henry Paulson – into a series of Fed rate hikes to 2.75% this year remains to be seen. For now, the Fed is hoping that "jawboning" will do the job of containing the upward spiral in commodities, and support the Dollar, giving it room to avoid raising interest rates as the US economy sinks deeper into recession.

To read the rest of this article, visit and subscribe to Global Money Trends now. You'll also get insightful analysis and predictions of top stock markets around the world, commodities such as crude oil, copper, gold, silver, and grains, plus foreign currencies and interest rates as well as global bond markets...

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


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