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Gold vs. Dollars: A Crisis in Fiat Currency

The Fed is playing Russian Roulette with the Dollar, and Gold Prices continue to benefit...

governments of every political stripe distort data to promote their own self interests, it's hardly surprising that they present inflation data in a manner best suited to their particular needs.

   By the same token, it's entirely natural for official inflation data to be wildly at odds with the reality faced by consumers and businesses. And it's hardly surprising that data is then regarded with utter disbelief.

So nor was it shocking in mid-January to hear Federal Reserve officials insist that inflation in the United States is under control, before telegraphing another tidal wave of liquidity injections into the US economy for the months ahead.

"Stable inflation expectations give the Fed a lot of room for maneuver. If the evidence suggests that substantial policy easing is appropriate, I don't think we're going to face a risk of adverse inflation consequences," said St. Louis Fed chief, William Poole, on Jan 9th.

In 2008, an election year for the highest office in the land, American politicians from both sides of the aisle are quick to propose all kinds of fiscal stimulus and pork barrel projects to jump-start the sputtering US economy. But adding more monetary stimulus to the mix has the potential to ignite hyper-inflation in the US economy, and a speculative attack on the US Dollar in the $3.2 trillion a day currency market.

"It's difficult enough to make good policy in a complex economy and complex financial system," said Fed chief Ben 'B-52' Bernanke on January 11th. "Political considerations will play no role, and I assure you as strongly as I can, that we will be objective and analytical, and we'll do what's right for the economy."

It's now becoming increasing clear that the only prices the Fed is focused on these days are home prices – most crucially those supporting toxic sub-prime mortgage debt.

The Fed is pegging the federal funds rate in the direction of US home prices, mimicking the Bank of England as an asset-price targeter. Last week, nearby futures contracts on the Standard & Poor's/Case-Shiller index, a measure of home prices in the top-ten US cities, fell to stand roughly 7% lower from a year ago.

Robert Shiller, a Yale University economist – and co-founder of the widely watched house-price index – cited on Dec 31st the possibility that the US economy may stumble into a Japanese-style recession, with house prices declining for years to come.

"American real estate values have already lost around $1 trillion. That could easily increase threefold over the next few years. This is a much bigger issue than sub-prime. We are talking trillions of dollars' worth of losses."

Shiller noted that Chicago futures markets are pricing in further declines in US home prices, with farther-dated contracts on the S&P Shiller Index pointing to losses of up to 14% by the bottom.

In the third quarter of 2007, US homeowners withdrew $20 billion less in equity from their homes than in the prior quarter, and since housing prices have continued to tumble, the outlook for cash-outs has continued to dim.

Lenders have also grown more cautious in handing out cash through home equity lines of credit, since those loans were failing at their highest rate in ten years during the third quarter.

If the US housing market continues to sink this year, consumers will have less home equity to convert into cash, which could lead to a big pullback in spending. With consumers struggling with high energy costs and a softening jobs market, the drying up of home equity could usher in an economic recession.

Slumping home prices and a softer jobs market would increase foreclosures on many sub-prime home borrowers, and blow huge craters in the balance sheets of banks and brokers worldwide. Credit Suisse projects 775,000 homes with $143 billion of mortgage debt will go into foreclosure in the next two years.

Goldman Sachs estimates that losses in mortgage markets worldwide may reach $726 billion...

Some BBB-rated sub-prime mortgage bonds have already tumbled to 16-cents on the Dollar, down from 50-cents last July.

AA-rated paper isn't faring much better, fetching only 40-cents on the Dollar in the $1.8 trillion sub-prime mortgage market. On January 15th, Citigroup – the nation's largest bank – took a fourth-quarter loss of nearly $10 billion, stemming largely from $18 billion of write-downs of sub-prime mortgages.

The deepening gloom in the US financial sector came as Bank of America agreed to acquire battered mortgage lender Countrywide Financial for $4 billion, averting one of the biggest collapses due to the toxic sub-prime debt bomb.

Merrill Lynch, meantime, is expected to suffer $15 billion in losses stemming from soured mortgage investments, as the sub-prime debt bomb goes nuclear.

Gold vs. Dollar: Bernanke Signals More Rate cuts in Q1

With the US economy sinking deeper into the "Stagflation" trap, and credit worries clogging the arteries of the London interbank lending market, Mr Bernanke shouted loud and clear for the whole world to hear on Jan 10th that the Fed and the US Treasury (also known together as the "Plunge Protection Team" or PPT) have decided to exercise the "Greenspan Put" option.

They will simply disregard elevated inflationary pressures in the rest of the economy, and cut rates in an attempt to keep asset prices inflated.

"In light of recent changes in the outlook for and the risks to growth, additional policy easing may be necessary," Bernanke said on January 11th. "We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks. Inflation expectations are reasonably well anchored."

For the Plunge Protection Team, the devil of hyper-inflation is preferable to the specters of a bear market for the Dow Jones Industrials and fast-weakening US home prices. Exercising the "Greenspan Put" means the Fed will slash the federal funds rate far below the US inflation rate in the months ahead. But that's a frightening prospect for foreign holders of $2.3 trillion of US Treasury debt, who must contend with negative interest rates, which in turn, could severely weaken their US dollar denominated investments.

The Fed is signaling aggressive rate cuts at a dangerous time.

Inflationary pressures in the US economy are elevated at multi-decade highs. US producer prices were up 6.3% last year, and US consumer prices up 4.1%, the fastest rate of price inflation in 17-years. It compares with only 2.5% for 2006 as a whole.

Gasoline costs were up 37% last year, and food prices were up 9.3%, embedding inflation fears into the American psyche.

Thanks to the Fed's cheap Dollar policy, US import prices also rose, up 10.9% in 2007 to record the largest calendar-year increase since 1987. The Dow Jones AIG Commodity Index soared to an all-time high of 193.25, exerting upward pressure on raw material costs – and the Gold Market, that bellwether of rising inflationary fears, rose by more than one third.

Only one lone voice of reason from Foggy Bottom is advising caution. "I would be very careful, not to let inflation accelerate too long," warned Thomas Hoenig, chief of the Kansas City Fed, on January 10th.

But Hoenig was rotated off the Fed's interest rate setting committee after he dissented against a rate cut in October. He favored keeping Fed policy on hold. But the politically correct thing to do in Washington these days is to cut rates and drop dollar bills across America from helicopters, if not from B-52 bombers.

Gold vs. Dollar: The Fed's Big Gamble

The Fed is betting that a sharp slowdown in the global economy will weaken commodity prices – and that Saudi Arabia will pump more oil – to keep inflationary pressures at bay.

Until now, the Fed's rate cutting campaign, plus its special $80 billion liquidity injection scheme and promises of another big tidal wave of liquidity, have severely weakened the value of the US Dollar. That in turn fueled parabolic rallies in crude oil and precious metals – including Gold Prices – to all-time highs.

Federal Reserve rate cuts also fueled "Agri-flation" worldwide, pushing March wheat contracts traded in Chicago up to $9.40 per bushel after the USDA reported smaller than expected US plantings for hard red winter wheat.

Corn surged to an 11-year high of $5.15 per bushel on a big drawdown in US corn stocks, while July soybeans soared to $13.76 a bushel, buoyed by fears that corn's surge could cut into soybean plantings for 2008. Rough rice futures in Chicago hit an all-time high of more than $15 per hundredweight, 37% higher from a year ago.

Egypt is a major exporter of rice, but it has suspended exports indefinitely due to hoarding and speculation in its local economy. In Pakistan, meantime, armed guards escort trucks carrying high-prized wheat. India will become a net importer of rice this year for the first time.

The Kingdom of Jordan intends to double its stocks of wheat to 390,000 tons, equivalent to six months of supply, plus a further 130,000 tons purchased and being shipped, representing two months of supply.

Doubling wheat stocks is an indication that some major importers see no end to the bull market in Chicago and want to protect themselves. Ocean shipping costs for dry goods have fallen 35% in recent weeks, which may encourage more purchasing of grains.

Gold vs. Dollar: Bush Seeks Quick Fix to Tame Oil Prices

On his arrival in Riyadh on January 15th, President Bush urged Saudi king Abdullah to put more crude oil onto the world market, warning that soaring prices could cause an economic slowdown in the United States.

"High energy prices can damage consuming economies," said Bush. "When consumers have less purchasing power, it could cause the economy to slow down. I hope OPEC nations put more supply on the market. It would be helpful."

Saudi Arabia is the only member of OPEC with spare capacity – roughly 2.8 million barrels per day. Saudi Oil chief Ali al-Naimi said on Jan. 15th that Riyadh is ready to boost oil output if the market needed more oil to tame high prices.

"Nobody would look with pleasure on a recession in the United States," said the Saudi oil minister. "Concerns about US economic growth are valid. But the price of oil is about more than just the US economy.

"Global economies are growing despite oil prices ranging between $90 and $100 a barrel," al-Naimi noted. And China's oil imports, for instance, rose 12% last year to a record 3.26 million barrels per day. But al-Naimi also blamed speculators in London and New York for inflating the price of crude oil by $20 to $30 per barrel.

"Twenty to thirty dollars is the outside influence on the price of oil. If you look at who's in the market, you'll find a lot financial institutions are speculating, using the market as a hedge."

Still, Naimi wouldn't say if Riyadh would agree to boost oil output at OPEC's Feb 1 meeting, and his boss – King Abdullah of Saudi Arabia – must walk a along a tightrope, balancing his military patron's request for more oil against Iran's opposition to further increases in output, which could hurt Tehran's oil revenue.

On Dec 5th, Iran's President Mahmoud Ahmadinejad scored a big victory when he convinced King Abdullah to join the hawks of OPEC – Iran, Libya, and Venezuela – and hold the cartel's oil output steady at 27.25 million bpd.

"Our position is that demand and supply are balanced and there is no need to increase oil to the market," said Iranian oil minister Gholamhossein Nozari. Still, the key question is which way will Saudi oil policy lean at the upcoming Feb 1st meeting in Vienna.

In favor of US President Bush or Iran's Ahmadinejad?

However, Riyadh is keen to keep oil prices elevated within a higher target zone, helping to sustain the enormous flow of petro-dollars into the Gulf which has revived the speculative appetite for the local stock market.

The Saudi All Share Index hit the psychological 12,000 barrier in mid-Jan., enriching the brokerage accounts of the 7,000 Saudi princes who control 70% of the market.

Gold vs. Dollar: Beijing Warns US Treasury on Further Fed Rate Cuts

Beijing also finds itself in a tough predicament, with $1.53 trillion of foreign exchange reserves built up over the past five years, mostly stockpiled in depreciating US dollars.

However, Chinese leaders have finally woken up to the folly of such a foolish investment policy. "The world's currency structure has changed," declared Xu Jian, vice director of the People's Bank of China (PBoC) on Nov 7th.

"The US Dollar is losing its status as the world reserve currency."

"We will favor stronger currencies over weaker ones, and will readjust accordingly," added Cheng Siwei, vice chairman of China's National People's Congress, and on Dec. 27th, the director of China's Foreign Exchange department – Hu Xiaolian – wrote that:

"If the US federal funds rate continues to fall, this will certainly have a harmful effect on the US Dollar exchange rate and the international currency system."

Traders are closely watching any change in China's strategy which could affect exchange rates. China's central bank is tightening its monetary policy to combat inflation, which is raging ahead at a 6.5% annualized rate. At the same time, the Bernanke Fed is preparing to flood global money markets with another tidal wave of cheaper US Dollars.

China raised benchmark interest rate six times in 2007, but the benchmark one-year deposit rate of 4.14% is still far lower than the inflation rate.

"We must be sure about one thing, the central bank is moving towards the objective of positive real interest rate instead of moving away from it, "said Yu Yongding, a key advisor to the PBoC, on Janaury 3rd.

The next day, the PBoC vowed to further tighten monetary policy in 2008, aiming in particular to prevent inflation from spreading out of certain sectors and into the broader economy.

Twelve months ago, the US Treasury's 5-year bond was yielding 2.0% more than China's 5-year note.

But today, the US T-note yields 1.2% less, putting enormous downward pressure on the Dollar/Yuan exchange rate, and cementing big foreign currency losses in Beijing's portfolio of US bonds.

According to forward traders in Hong Kong, the Dollar is expected to fall another 9% to 6.6 Yuan over the next 12 months. No wonder then that since March 2006, China has been a net seller of US Treasury debt, reducing its exposure from $421 billion to $386.7 billion in Nov. '07 and seeking to avoid further losses on the Dollar's exchange rate with the Yuan.

"The weakening Dollar and rising global commodity prices are also creating inflationary pressures for China, but a quicker appreciation of the Yuan would probably help offset some of those price increases," said Yao Jingyuan, chief economist of the state statistics agency.

On Jan. 16th, the PBOC hiked bank reserve requirements by 0.50% to a record 15%, a move that will drain 200 billion Yuan (some $28 billion) from the Shanghai money markets.

The Dollar has now fallen to 7.23 Yuan – down by 3.2% – since late October, a faster decline than the 1.2% slide in the US Dollar Index over the same period. That means the Yuan is rising at an even faster pace against a basket of six major global currencies, including the Euro, British Pound, and Canadian Dollar.

Gold vs. Dollar: Arab Oil Kingdoms are Saviors of USD

Japan remains the largest holder of US Treasury debt, but it has been a net seller of $46 billion, and South Korea has sold $19 billion over the past 12 months, too.

To pick-up the slack, the Bush administration has relied heavily on the Arab Oil Kingdoms, inviting them to recycle their bulging petro-dollar surpluses back into US Treasury debt.

Since 9/11, America has assumed the financial costs of occupying Iraq and Afghanistan, while the Arab oil kingdoms have experienced a staggering infusion of new wealth. Saudi Arabia has taken in nearly $900 billion in oil revenues over the last six-years, and the emirate of Abu Dhabi has a sovereign wealth fund approximating $1 trillion.

There had been a time, in the lean 1990s, when Saudi Arabia's debt reached 120% of Saudi GDP, but today it has fallen to 5%. And from a year ago, it is estimated that the Arab oil kingdoms have recycled as much as $227 billion into US Treasuries, mostly through their brokers in London.

In order to keep the Saudis' archaic Dollar/Riyal peg intact, the Saudi central bank has more doubled the growth rate of its M3 money supply to 21.6% per year, trying to stay ahead the of Bernanke Fed's 16% expansion of the US money supply.

The Saudi central bank has cut its key repurchase interest rate (the benchmark for cash deposits) to 4%, acting right in tandem with the Fed. But the rapid growth of the money supply pushed Saudi inflation to 6% in October, it's highest since 1995. Food price inflation hit 7.5%.

Inflation in four of the six Gulf Arab Oil Kingdoms has overtaken official lending rates, encouraging speculation in real estate, which is the main cost of living across the region. Saudis blame King Abdullah's insistence on pegging the Riyal to the US Dollar for higher inflation at home. The central bank is handcuffed in the fight against inflation by the Riyal's peg to the Dollar, which forces it to track US monetary policy at a time when the Federal Reserve is cutting interest rates.

Those who can afford to Buy Gold have protected their wealth from the Saudi central bank's new flood of money. But most of the Saudi population hasn't been so fortunate.

"We remind you of Prophet Mohammad's words that you are shepherds who are responsible for your flock," said 19 well-known clerics, including Nasser Al Omar, on Dec 16th. "The rulers should seek to try to remedy this crisis in a way that would ease people's suffering. This crisis will have a negative impact on all levels, causing theft, cheating, armed robbery and resentment between rich and poor."

Gold vs. Dollar: Breakdown of Fiat Currency System

In a world of fiat (paper) currency, the full faith and trust in a nation's money often lies in the policy actions and honesty of its central bankers. But under the Bernanke Fed, global confidence in the US Dllar has been badly shaken, and the Fed rookies hand picked by President Bush are just learning about Gold Bullion's special role in the international monetary markets.

Trading in the foreign exchange market is akin to a reverse beauty contest, judging the least ugly (least inflated) currency as the winner. Already two central banks – in Canada and England – have joined the Fed's money printing orgy.

But gold cannot be printed, and mining output is running 9% lower than a year ago. The Bernanke Fed, meantime, is playing Russian roulette with the greenback, and it threatens a serious breakdown of the fiat paper currency system worldwide.

If you want to stay on top of the resulting volatility, trading the top stock markets around the world – as well as commodities such as crude oil, copper, gold and foreign currencies, interest rates and global bond sure to subscribe to
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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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