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The Fed, the Dollar and interest rates

The US trade deficit will crush the Dollar as the Fed fails to hike interest rates...

Global Watch: 12th May 2007
A snippet from the latest weekly issue of

THIS MONTH the Fed's Open Market Committee repeated its assessment from March – that persistent inflation remains the predominant policy concern. Yet Dollar interest rates were held at 5.25%.

   The Fed has, in fact, just said that "inflation is a predominant risk". But it did not raise interest rates. Indeed, the Fed indicated that it is not likely to do so, pointing to slower growth and the ongoing problems in real estate.

   This gives the impression that the Fed will react to higher inflation but will not pre-empt it. The dangers of inflation plus falling growth – known as "stagflation" – are now apparent. It would be gold positive too, but Dollar negative. The US trade deficit will continue to grow at excessive levels, whilst the climate could switch to discouraging Asian nations from investing their surplus Dollars back into the States.

   Caught between lower growth and inflation, the Fed is now caught between a rock and a hard place. It's unlikely to move interest rates one way or the other until one risk overrides the other completely. Here at we have said over a very long period that the Fed must guard against falling growth – even if inflation takes off. Growth is extremely difficult to engender, whereas inflation is manageable, without damaging jobs.

   The FOMC reiterated that "the committee's predominant policy concern remains the risk that inflation will fail to moderate as expected." However, the US economy is still likely to grow at a moderate pace in coming quarters. We at the would suggest you keep a very firm on US growth figures.

   Should growth begin to slide, be sure that inflation fighting will retreat and sit in the trenches. Monetary stimulation will lead the charge. It would be a mistake to think that the Fed will raise rates to attack inflation whilst there remains the slightest risk that growth would be damaged.

   Last quarter, the US economy expanded at a 1.3% annual rate, handicapped by a 17% slide in residential investment, the sixth quarterly decline. At the same time, unemployment was 4.5% in April, close to a five-year low. With falling growth, all eyes are on the way forward. Is it to stagflation, or inflation, on the back of sound growth? The answer to this will dictate the way forward for the Dollar – and gold.

   Following the Fed's March meeting, investors had expected a rate cut in the third quarter. Now the bond market has postponed its expectations to the final three months of this year. Two-year note yields rose 6 basis points following the Fed's May decision, rising to 4.73%.

   Then there's the US trade deficit. Rising to $63.9 billion in March, it continues at such a level as to undermine the Dollar – and should continue to do so for the foreseeable future. At the same time as this data release, Henry Paulson, US Treasury Secretary, advocated a "strong Dollar" at market rates (a contradiction in terms?). The Dollar showed initial strength, rising out of the danger zone between $1.35 to $1.37 per Euro. Thus media attention concentrated on the Dollar rising above last month's record-low level, rather than on the amazing accumulation of the US trade deficit over the year, added on top of previous years.

   To emphasize what we are saying here, imagine the trade deficit were twice the present level, a level to cause global Dollar indigestion. What would be the consequences? Clearly, a tumbling Dollar.

   The reality is that the US trade deficit looks certain to continue at these levels in the future. Once it has gone on for twice as long, it will result in the same damage to the Dollar. In other words, at some point in the future the deficit just will not be accepted and the Dollar will crash.

   Imagine a bank customer, borrowing persistently from the bank with no hope of ever repaying the debt. What would happen? Now imagine this customer is the only client of the bank – or indeed of several banks. What would happen?

   Quite frankly it is in the interests of all parties to ensure that the myth of a steady Dollar exchange rate, held there by intervention by surplus holders, will be blown away someday. Until then, and so long as it can be translated into goods at present values, the situation serves surplus Dollar holders to support its value. It does not serve the US government, however, as jobs and capital ownership shifts eastwards.

   Perhaps this sapping of the United States' global economic strength is deemed unavoidable. Perhaps the authorities are making sure that the weakening is done without pain, as no other solution is available?

   Validating our belief that a growing US economy sucks in imports, during March imports and exports both rebounded to their second-highest levels on record – but imports rose faster than exports. Imports of goods alone rose 5.1% to $160.3 billion in March. In addition to oil, the US imported more autos, consumer goods, and food. Exports of goods, meanwhile, rose 2.0% to $90.2 billion. US exports of industrial supplies, autos and consumer goods rose in March.

   Of course, the higher oil price had a significant impact on the Balance of Payments, as the petroleum deficit widened 2.6% to $45.5 billion, the largest deficit since last September. The US imported 324.2 million barrels of crude oil in March, or 10.5 million barrels per day, marking the highest level since last August. These figures compared with 252.9 million barrels (some 9.0 million barrels per day) in February.

   The average price per barrel of oil imported to the US rose to $53 in March, its highest level since December. With the oil price rising through and over $60 a barrel, expect next month's trade numbers – showing the deficit in April – to widen accordingly.

   The prognosis on the US trade front is not good. The Dollar should reflect this. We believe intervention is currently preventing the Dollar's natural response against strong flows of 'carry trade' money and the investment of surplus Dollars back into the States.

   This leave the question begging: Just how long will the US or anyone else allow it?

JULIAN PHILLIPS – one half of the highly respected team at – began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the "Dollar Premium". On moving to South Africa, Julian was appointed a macro-economist for the Electricity Supply Commission – guiding currency decisions on the multi-billion foreign Loan Portfolio – before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

There he specialized in gold, before moving to Capetown, where he established the Fund Management department of the Board of Executors. Julian returned to the "Gold World" over two years ago, contributing his exceptional experience and insights to Global Watch: The Gold Forecaster.

Legal Notice/Disclaimer: This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold Forecaster/Julian D.W. Phillips have based this document on information obtained from sources they believe to be reliable but which it has not independently verified; they make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold Forecaster/Julian D.W. Phillips only and are subject to change without notice. They assume no warranty, liability or guarantee for the current relevance, correctness or completeness of any information provided within this report and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Furthermore, they assume no liability for any direct or indirect loss or damage or, in particular, for lost profit, which you may incur as a result of the use and existence of the information, provided within this report.

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