The Daily Reckoning Australia » Oil and Gold

U.S. Dollar Retreating Against Commodities

Dan Denning — Tue, 16 Dec 2008 01:54:59 +0000

Like a giant laxative in the world's monetary system, the Federal Reserve's quantitative easing is starting to have an effect. You wouldn't necessarily call it the desired effect. After all, we're talking about the eventual destruction of the U.S. dollar and the global monetary system upon which it's based. But it's an effect nonetheless.

Both the Aussie and New Zealand dollars were up against the greenback. These two are probably not rising because they are commodity currencies. The strength of commodities versus the U.S. dollar is only relative at the moment. But the interest rate differential might be a factor.

The Federal Reserve Open Market Committee meets in America today. Economists surveyed by Bloomberg expect the U.S. central bank to cut short-term rates to just twenty five basis points. That will put them at just 0.25%. Though pathetic, the move is largely symbolic.

The Fed is prepared to go "into the wild" if Ben Bernanke is to be believed. Consider the facts. U.S. government debt is already at $10.5 trillion. The Fed's balance sheet assets are at over $2 trillion and growing. America's deficit spending set to explode in 2009. The Fed HAS to go unconventional and pursue some kind of fourth generation monetary warfare against deflation.

Here's what you can expect. The Fed's next move will be adding other assets to its balance sheet. It will pay for these assets with new money borrowed by the Treasury or brand new money altogether. Sometime in 2009 this will lead to an exodus out of the U.S. dollar. Fortress Treasury Bonds will crumble. The popping of the bond bubble will drive up oil and gold. Both were on the move yesterday.

But what to your wondering eyes will appear as the Fed charts its new course into the monetary wild? Well, the first..ahem...assets the Fed may pursue are securities backed by U.S. mortgages. Remember, the Fed is trying to drive down short and long-term rates in the U.S. to bring mortgage rates down.

If mortgage rates come down and bank balance sheets are sufficiently repaired, then the Fed hopes the entire manoeuvre will engineer a bottom in the U.S. housing market. The collapse in residential real estate is at the epicentre of the whole wealth destroying phenomenon to begin with. The Fed strategy is both direct and indirect strategy. Let us compare it to military strategy for just a moment.

In his book "Strategy," British historian B.H. Liddell Hart suggests that the key to unlocking the stalemate on the Western Front in World War One was an indirect attack through Turkey and the Balkans. Attempts at decisive, game-changing confrontations (like the battle at Verdun) only resulted in massive casualties. The only way the British and the French could really threaten Germany was by opening up a new front in the East, which meant going 'round the long way. This puts Gallipoli in an interesting strategic light.

Hart was a big advocate of the indirect strategy, attacking your enemy where he least expects it and achieving the element of surprise. Other military strategists and historians like Clausewitz and Victor Davis Hanson believe that direct, decisive major battles have played a more important role in history than the indirect approach. So what does this have to do with the Fed and gold?

The Fed has already tried the indirect approach to reliquefying capital markets and arresting the fall in U.S. home values. It's tried interest rates and a whole array of lending programs. The indirect approach has failed. So the direct approach is what remains, although by Fed standards, it is not a tactic the Central Bank often resorts to. It is crude. It relies on brute force and money printing.

The direct method is to support security and asset prices by buying them. If you can't make a market work, make the market. Be the market maker. The Fed will start buying mortgage backed bonds. And it probably won't stop there.

Though it is bound by the number zero when it comes to interest rates, the boundaries of quantitative easing are theoretically limitless. As long as the appetite for U.S. bonds grows, the Treasury can keep selling them and feeding the proceeds to the Fed. With this money, in theory, the Fed could buy anything it wanted to and put it on the balance sheet...baseball cards, pin ball machines, expensive paintings, or even discount mulchers from Wal-Mart (to turn all that new green paper into something truly useful).

Does all this mean anything for Aussie investors? Of course! While the bounds of Fed borrowing are theoretically limitless, investors will eventually not support the U.S. government's monetary and fiscal policies. Interest rates in the U.S. will go up and the dollar will go down.

With the U.S. dollar retreating against other currencies, it will also retreat against commodities. In fact, the dollar's move this week doesn't look so much like a retreat as it does a gradual losing of the ground it claimed in the last few months. Perhaps the strategic tides are turning.

If they are, it means the market's bias is shifting away from recession fears in 2009 toward inflationary fears now. Equities have priced in recession. No commodities will price in inflation.

That should lead to higher commodity prices. And for those commodities that are also money (gold, and to a lesser degree, silver) it should be good news. What might hurt Aussie investors in this respect is a stronger Aussie dollar-unless the U.S. dollar price of gold rises faster than the AUD/USD. We've got Al Robinson working on this very subject in a special year-end gold and silver edition of Diggers and Drillers. Details to follow next week.

That is the trouble with the world of paper money. Everything is relative. Nothing is completely rational (although nothing ever is). The Fed may give the appearance of acting with due measure. But it probably has no idea what it's doing. It's using exact methods and theories for an inexact world.

Or, as G.K. Chesterton put it, "The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait."

Dan Denning
for The Daily Reckoning Australia

Fed is Trying to Keep the Money and Credit Moving: Commodities, Food, Oil and Gold

Bill Bonner — Wed, 07 May 2008 05:31:08 +0000

It is the best of times...it is the worst of times.

This morning, oil is over $120...and the price of gold is pushing back up to $875.

That's good news, say the headlines. Oil is up because people think the United States will avoid a recession. "Oil tops $120 a barrel as U.S. optimism rises," says a headline in the Financial Times. And many think the Hillary/McCain summer gas tax holiday concept may be implemented - which would encourage people to use more gasoline!

John...Hillary...good thinking. Get people out on the road...using more fuel. Great idea. Even Thomas L. Friedman can see what vote-pandering imbeciles you are (more below...). Need we say more?

But say more we will...because, on page 1 of the Financial Times is a photo of a mob in Africa... What has stirred them to riot? The latest election result? Someone dissing their religion? No, high food prices!

It is the worst of times for people with big appetites and little money. Many of them will go hungry. And an empty belly is a dangerous thing. First, people develop a "lean and hungry look." Then, they stab you in back.

Ah yes...predictably...inevitably...the world's intellectuals, economists, yahoos, and pandering politicians are having trouble following the trail. They ought to look down at their feet. They would see the breadcrumbs...from the door of the Fed's headquarters in New York...through the deep woods of subprime and leveraged derivatives...and right up the hill of soaring commodity and gold prices. That's right...the Fed is trying to keep the money and credit moving. But it is going where it wasn't supposed to go - into commodities, food, oil and gold. Still, the experts can't see it. Instead, they read the polls, watch the TV, and come to the wrong conclusion. What is the cause of the rise in food prices, they ask? Speculators!

Another lead story today: "India targets food futures." India imagines that food prices are being driven up by greedy hedge fund managers. It is considering a "blanket ban on food futures trading," says the FT.

Why not? Nothing is too absurd or too counterproductive to escape the notice of the world improvers. Just look at John McCain's big idea - a "league of democracies." More about that coming up soon too... For now, let's stick with the financial news...

The big story seems to be the idea that, as our chief financial researcher in London, Theo Casey, put it: "doom and gloom has been overplayed."

Since the drama of Bear Stearns, no other major financial firm has failed. Quick action by the Fed and other central banks seems to have saved the world.

"Has the worst of the financial crisis passed?" asked Le Monde yesterday.

"Yes," said the world's richest man over the weekend. Warren Buffett told his shareholders that the "worst of the credit crisis on Wall Street is over."

Maybe he's right. But let's look at the numbers. In 2006, alone, nearly $7 trillion of new debt was issued worldwide. Maybe double that amount in the entire five-year period - 2002-2007. So far, says Bloomberg, since the beginning of 2007, less than $200 billion has been written off. You can do the math yourself, but Fred Y. Jones guesses that total losses so far probably don't exceed 1% of the debt sold in the last 5 years.

So far, so good, in other words. This is the best of times. The Fed has cut rates 7 times. And it now takes on its balance sheet - as collateral for loans - the very credits that are likely to go bad...credit card debt, student debt, and even car loans. It has only 200 basis points left, before it gets to zero, and there are approximately $10 trillion (just guessing) worth of credits that still could go bad. If just 5% of them went bust...the loss would be $500 billion. Maybe the doom and gloom is underplayed. Moving bad debt from the people who deserve it to the Bank of All the Americans - the Fed - doesn't turn the bad credits into good ones. It merely allows everyone to keep doing what they've been doing...that is, to keep pretending that everything is all right.

But everything isn't all right. Far from it. And budding out in our brain is a little idea about why the situation can't be fixed...and why a major breakdown may be on its way...more to come...about how democracy and modern, state-guided capitalism really work.

Interestingly, Buffett is famously pro-America. You bet against American business and you will go broke, he says. But over the last 10 years, betting against American business was the best thing you could do. The dollar sank...and foreign markets - particularly emerging markets - soared.

Buffett hasn't missed the point. He paid $4 billion for an Israel-based metalworking company in 2006. And now he's coming to Europe to scout for opportunities. He'll no doubt want to stop by The Daily Reckoning headquarters in London for our advice.

Warren, look for the building with the golden balls. We're waiting for you.

Bill Bonner
The Daily Reckoning Australia