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Gold & Ultra Easy Money

As go commodity and Gold Prices, so goes the direction of Producer Price Inflation...

OPERATING under the influence of ultra-low interest rates and flush with trillions of fiat currency at their disposal, hedge funds and banking oligarchs are once again making risky and daring bets in commodities, emerging markets, junk bonds, and blue-chip stocks, writes Gary Dorsch of Global Money Trends.

Courtesy of the world's central bankers, they're defying gravity with trades that would have been un-thinkable just six-months ago.

The "Group-of-20" major economies have now committed $12 trillion of taxpayer money to engineering this 180-degree turnaround in trader psychology, equivalent to a fifth of the entire globe's annual economic output. The euphoric illusion of V-shaped recoveries has taken us from the chronic fear of meltdowns last year to the opposite side of the spectrum.

The G-20's largesse has been used to fund capital injections into banks, soaking-up toxic assets, guaranteeing financial company debt, and flooding the world credit and stock markets with ultra-cheap liquidity.

On Sept 20th, the G-20 nations – which account for 90% of the world's output – agreed it was too soon to begin withdrawing the $5 trillion of surplus cash that's been injected into world money markets. The IMF estimates that banks in Britain, the Eurozone, and the United States have recognized slightly less than half of the $3.4 trillion of bad loans sitting on their books, and are still struggling to absorb heavy losses primarily from failing US mortgage loans.

The G-20 says it's drawn-up plans for coordinated exit strategies that would drain trillions of Dollars of liquidity, but such measures are still seen unlikely until sometime next year. On Sept 25th, US Treasury chief Timothy Geithner noted that although the global economy has pulled back "from the edge of abyss" and was showing early signs of resuming growth, it's too early to let-up on the monetary accelerator.

"We still have a very long way to go," he said.

Lacking a better strategy for rescuing the banking system and preventing the global economy from plunging into another Great Depression, central bankers fired-up their printing presses, aiming to inflate asset values on the stock exchanges.

By artificially boosting investor portfolios with cheap money, the top-20 administrations and their central bankers hoped to boost the confidence of households through the so-called "wealth effect".

On March 16th, the Federal Reserve turned to the nuclear option of central banking, adopting a radical policy known as "Quantitative Easing" (QE), announcing that it would print $1.75 trillion in order to purchase $300 billion of Treasury notes, and $1.45 trillion in mortgage-backed bonds. By flooding the money markets with a steady torrent of zero-percent money, traders became more brazen and daring, willing to bid-up the Dow Jones Industrials by 54% over a span of six-months, one of just six rallies of that magnitude in the last 100 years.

By reaching the psychological 10,000 level, the Dow Industrials hit a spot that few could have imagined when the Dow skidded to a 12-year low of 6,497 on March 9th. The stock market's gains were led by technology, industrial, and consumer stocks which normally feed on clear signs of an economic strength. Indeed, the US economy has also emerged from its deepest slump since the 1930s, expanding at a +3.5% annual rate in the third quarter – the early stages of a "technical" recovery.

Yet the US jobless rate is also expected to continue climbing higher, rising above the psychological 10% level and signaling that severe economic distress still lies ahead.

There have been eleven recessions since World War II. In the two most recent ones – July 1990-March 1991 and March-November 2001 – job growth lagged far behind after the recessions were declared over. The jobless rate did not fall to pre-recession levels for several years thereafter.

The lesser known U-6 jobless rate, which includes the long-term unemployed and part timers seeking full-time work, is hovering at 17%, reminiscent of the Great Depression era.

Thus, the US stock market has been climbing a "wall of worry" amid a cautious sense of optimism, but also beset by underlying jitters. The economy faces a rocky road and the Dow Industrials might not stay above 10,000 for long.

When measured in "hard money" terms, or in relation to the price of Gold, the Dow Industrials is trading at 9.5 ounces – the same exchange rate that prevailed when the Dow was at the 8,200-level in January. Thus, utilizing this simple measure of valuation, more than half of the Dow's post March 10th rally – or roughly 1,800 points – is simply an optical illusion. More specifically, a stock market bubble has been inflated by the Fed's QE money-printing scheme.

Speculators are profiting from the hallucinogenic side-effects of "nuclear QE", but the stock market's spectacular gains haven't spread to the wider economy. Instead, the money being pumped in via central banks is in fact only inflating financial bubbles. Oligarchic banks are reportedly hoarding much of the excess cash, parking funds in government and corporate bonds, commodities, and equities.

In the last stage of a equity bubble, traders believe there is easy money to be made, and begin plowing their gains back into the market in a virtuous cycle. Price-to Earnings ratios get pumped up to high levels that can't be sustained through top-line revenue growth.

Martin Meyer, in his book The Fed, wrote that:

"The truth is that liquidity is the only significant weapon remaining in the central bank's arsenal as decision making moves to the markets. Liquidity will not necessarily go, where you want it to go, when you need it to go there."

Thus, while the Fed would prefer for the tidal wave of liquidity to flow strictly into bonds and stocks, one of the dangerous side effects of QE is that much of the excess cash is also filtering into the commodities markets – a signal that faster inflation lies ahead, even if much of its is generated by faster growing economies in the Far East and the emerging world.

Interest rates for US Dollar deposit rates in London's interbank Libor market have declined to a record low of just 0.28%, making the US Dollar unattractive to foreign lenders, who are already frightened by the prospect of trillions of US debt to hit the markets in the years ahead.

Amid fears the Fed will ultimately succumb to political pressures and monetize the debt – printing cash to pay the Treasury's expenses directly – the US Dollar fell to a 14-month low, lifting the Euro currency to the psychological $1.500 area and the Swiss Franc to parity at $1.00.

In turn, a weaker US Dollar exerted upward pressure on key commodities, such as crude oil, copper, rubber, iron-ore, nickel, and soybeans, leading to the rapid unwinding of deflationary pressures in the commodities markets. In the past four months alone, the Dow Jones Commodity Index, a basket of 19-exchange traded commodities, has rebounded from an annualized decline of 52% in early July and surged into positive territory hitting +7% last week.

Typically, as goes the direction of commodities markets, so goes the direction of the Producer Price Index.

The combination of ultra-low Libor rates, a sliding US Dollar and higher commodities has pushed the Gold Price above the psychological level of $1000 an ounce – a barrier it's managed to stay above for an entire month.

In a virtuous cycle, gold's rally mirrored the rapid unwinding of deflationary pressures in the commodities markets. And as such, gold might become the next asset bubble if G-20 central banks continue to print money.

This is especially true in the event of a currency crisis in which gold's buying power will increase from a devalued US Dollar in the currency markets. The US Dollar has been under selling pressure since October 6th newspaper report said the Arab Oil kingdoms in the Persian Gulf are secretly aiming to replace the US Dollar with a basket of currencies in exchange for their crude oil.

The basket of currencies reportedly includes the Euro, Japanese Yen, Chinese Yuan and Gold.

Whether these secret maneuvers are fact or fiction, the US Dollar did briefly tumble to a 14-month low after People's Bank of China (PBoC) vice-governor Yi Gang advised Beijing to increase the share of Euros and Yen within its $2.25-trillion stash of foreign currency reserves.

"The diversification of China's foreign exchange reserves in different currencies is our long-standing policy," he said.

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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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