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Wow! What a beauty…

Here at the Daily Reckoning, dear reader, we are connoisseurs of absurdity. We collect absurdities the way some men collect beer bottles or stamps.

Most highly prized are those where the absurdity is both profound…and right on the surface where everyone can see it. We also have a fondness for those in Latin, quoted by tweedy professors as if they were true.

"Cogito ergo sum," Rene Descartes wrote; I think, therefore I am. "How did he know?" we ask with malicious delight. "Too bad he didn't think he was a beer truck; at least then, his friends could have enjoyed a brew."

Heh…heh…

Well, on our shelf, next to Descartes, we maintain a prominent place in our collection for a more modern absurdity, in English:

"Monetary policy always works," said Wayne Angell on CNBC last week.

Angell was discussing the most recent bit of monetary policy to fall upon the nation - the Fed's 12th rate cut. The first 11 cuts may not have quite done the trick, the former Fed governor admitted, but this one certainly would.

Monetary policy is simple enough. You lower the cost of money - or its supply - and thereby create a boom, which makes people better off. One need not be a Nobel-prize- winning economist to spot the flaw. If it were that easy, why isn't the whole world rich? Even central bankers in Albania or Lithuania could get the hang of it with a little practice. Certainly, Argentina's central bankers have gotten quite good at increasing the money supply…they've practically destroyed that nation's economy, not once, but several times.

"You can pump all the money you want," explains Frank Shostak, "but it does not create anything; it only destroys. It causes a misallocation of resources, consumer capital, and makes everything worse."

The effect of the latest rate cut, says Shostak, will be to delay the recovery, not hasten it.

"Consumers find low interest rates cut both ways," notices a Houston Chronicle headline. Alas, for everyone paying interest, there is someone on the other end receiving it. That is part of the problem. While desperate debtors find their loads lightened a bit by lower rates, the excess weight falls upon creditors like a dead economist. The debtor may be able to spend more…but the poor creditor, often a retiree who relies on his savings, is crushed.

"Get ready for yields on U.S. money market mutual funds to fall far, far below 1%," warns the Houston paper.

During the Carter Administration, savers could put a dollar in a money market fund and receive 22 cents in yield. Now, they will be lucky to get a penny.

And yet, the same economists who were sure we'd be in full recovery - and that Greenspan would be raising rates by now - are now sure that this latest cut will force the issue. Who would want to save money in a money market at less than 1% yield? Consumers will want to consume even more, they believe - thus beginning a new boom.

"I still spend," the householders will think, "therefore, I am still rich."

People can think anything they want. But it ain't necessarily so… Eric…?

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- Stocks continued their post-rate-cut swoon yesterday, by falling for the third straight session. The Nasdaq Composite slumped 3% to 1,319, while the Dow dipped 178 points to 8,359.

- Gold fell one dime to $321.60 an ounce, while the bond market took the day off in observance of Veterans Day.

- Yesterday, we mentioned Sir John Templeton's surprisingly dire pronouncement that the US current account deficit - because of the risk it poses to the U.S. dollar - is the greatest threat imperiling the American economy. Morgan Stanley's Stephen Roach emphatically agrees with the 90-year old investment guru.

- "Never before," says Roach, "has a nation had to come to grips with annual external financing requirements such as those faced by the United States - now approaching some $500 billion and likely to rise toward $600 billion in 2003…The United States accounted for fully 71% of the total global deficit in 2001."

- Roach calls this imbalance "an accident waiting to happen." And yet, most Americans still manage to sleep soundly at night. They care no more about the current account deficit than we at the Daily Reckoning cared about Eminem's cinematic debut last weekend…

- Unfortunately, our national insouciance toward the current account deficit makes it no less threatening. America's dependence on external financing is growing at an alarming rate. "At the end of 2001," says Roach, "foreigners owned 18.3% of the total market value of U.S. long-term securities. By way of comparison, the pre- bubble reading at the end of 1994 was a mere 11.0%." Foreign ownership of U.S. Treasuries has more than doubled since 1994 to 41.9% at the end of 2001. Foreign ownership of US stocks and corporate bonds has been surging a like amount since 1994.

- "Finally," says Roach, "there can be no mistaking the sharply increased foreign appetite for the debt of U.S. federally sponsored agency securities (i.e., Fannie Mae and Freddie Mac); the foreign ownership share of such paper surged from 5.7% at the end of 1994 to 14.4% at the end of 2001." In other words, an ever-growing number of folks who are refinancing their homes have foreigners to thank for the loan.

- "Until the mid-1980s," Roach recalls, "the U.S. was still a net creditor to the rest of the world. Now its net international indebtedness is in excess of 20% of U.S. GDP…[This] external shortfall is very much a by-product of subpar national saving…The problem is that America's national saving shortfall is now getting worse again. The net national saving rate fell to a record low of 2.0% in 2Q02, less than half the 5% average of the 1990s."

- That's because saving is boring and spending is fun. So why would anyone want to save? And besides, won't the stock market - when it recovers - do most of our saving for us? Stocks always go up over the long run, right?

- We're living in the "post-prosperity economy," according to the New York Times…The prosperity itself may be gone, but not the fond memory of it. In fact, the memory of prosperity is so fresh that many folks expect the good times to return very soon, and this confidence, misguided though it may be, emboldens them to take on new debts.

- "Few consumers bothered to hunker down during last year's recession or this year's stuttering recovery," the Times observes. "Despite the loss of about two million jobs, the steep fall in the stock market and the Sept. 11 attacks, household spending has defied the traditional pattern and grown every quarter since the recession began."

- We American can't help it…Accumulating debts and spending money we don't have is part of our national DNA. Unfortunately, defaulting on our debt is another part of our DNA…And lately, these "bad genes" are showing up everywhere.

- Bankruptcy claims in October jumped nearly 15% above year-ago levels. Credit card delinquencies are soaring and mortgage foreclosures have jumped to a 30-year high…No doubt about it, there's nothing fun about trying to pay back money that you owe. So let's just hope that foreigners never ask Uncle Sam to pay them back.

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Back in Baltimore…

*** "It is not the money supply that really matters," we told listeners at the New Orleans Investment Conference, "It is the way it is taken up by the economy."

If banks don't lend and people don't borrow - the Fed's new money just sits in a big lump…as lifeless as a member of congress.

Business borrowing has fallen off since the slump began. Most of the lending is now in the real estate market. But even real estate is showing signs of slowing down. Homebuilding stocks are headed down. And lumber hit a 6- month low yesterday.

*** Since the bubble burst in Japan, the average house price has fallen in half, reports the Singapore Straits Times. Stock market losses are trivial in comparison, with $17 trillion in lost value from real estate…an amount equal to twice the nation's entire GDP.

*** China reported that its exports are growing at a phenomenal 14.2% annual rate. Either China will become the world's most important economy some day…or it will blow itself up trying.

*** "How's your modeling career going?" your editor asked his daughter by phone yesterday. Maria, 16, is an aspiring fashion model. Her Paris agency sent her to New York to work there for a month.

Her father, of course, wishes her well in her career. But he is worried. He knows what it is like to be all alone in a big city with no one to talk to…no one to have lunch and dinner with…no one with whom to share life's triumphs and sorrows. Of course, Maria is young and beautiful; she has an uncle and a grandmother in New York to keep an eye on her…and hardly a day goes by without an invitation from some admirer. But what about her father!? He does not like to see his little girl grow up so fast.

"It's going very well, Dad," comes the answer. "They want to send me to Los Angeles, too…"

"Great…"

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The Daily Reckoning PRESENTS: Long slow-motion deflation…or Fed-goosed inflation? They appear to be the only questions worth debating when it comes to the U.S. economy. With respect to the latter, an 'unanticipated' return of inflation offers potential profits for investors in commodities and natural resources…

THE INFLATION TRADE
by Andrew Kashdan

We're as skeptical as the next guy that the Fed's latest rate cut will be any more beneficial for the U.S. economy than the 11 prior rate cuts. But we're not skeptical at all that the Fed's easy-money policies, coupled with a rapidly growing money supply, will rekindle inflationary forces. The question is simply…when?

Governments do so few things well. But they have always excelled at inflating away the value of currencies. We see little reason to doubt that the Greenspan Fed's reflationary efforts will 'succeed.' In the meantime, certain market factors indicate that an immediate return to inflation is unlikely.

In fact, the financial markets seem to be anticipating a period of low inflation unprecedented in the modern era. Inflation-indexed Treasuries, for example, are pricing in an average inflation rate of about 1.5% over the next 10 years.

The last time the 10-year average inflation rate dipped below 1.5% was in the early 1960s. President Lyndon Johnson's Great Society was still in the incubation stage, and the escalation of the war in Vietnam had not yet begun. Will our next rendez-vous with ultra-low inflation occur as the war on terrorism is heating up, and the budget is falling further into deficit? Not unless Chairman Greenspan and his merry band suddenly decide that 'printing money' to pay for spending is a bad idea. (File that one under 'not bloody likely.')

As hurtful as inflation can be for the average Joe over the long term, it is very helpful for commodity prices. In fact, investing in commodities and natural resources is one of the very few ways in which an investor can profit from inflation. But a successful 'inflation trade' doesn't require a dramatic inflationary spiral. Even a slight uptick in the inflation data would be sufficient to create big profits for some trades.

For example, Eurodollar futures (Eurodollars are priced off of short-term interest rates) have been rising lately, effectively "pricing in" an expectation of low inflation and low short-term interest rates. In a recent issue of Outstanding Investments, John Myers and I recommended buying long-term puts on Eurodollar futures. These options will increase in value if short-term interest rates rise. And because of widespread concerns about deflation in the marketplace, puts on Eurodollar futures can be had at bargain-basement prices. Those who hang back from buying Eurodollar puts until it dawns on everyone that inflation is alive may well pass up a chance to profit from inflation's resurgence.

There's also money to be made in metals. Silver and copper prices have rallied nicely in the last month. The upturn coincided with the stock market's rally in October, as the metals tend to do well when economic optimism is on the rise. The interesting thing is that even in the face of a weak global economy this year, demand for base metals has remained surprisingly healthy. As a result, inventories of various metals like aluminum, nickel and copper haven't built up since July, as would typically be the case. Over the past few decades, there has been a seasonal inventory build in late summer when vacations, year-end changes by manufacturers and the move to indoor construction activity punched a hole in demand. But not this year. Furthermore, this year's change of pattern may be the beginning of a longer-term trend as a thriving China and offsetting seasonal effects around the world even out demand.

Copper consumption, in particular, is usually highly leveraged to an economic recovery. So, if demand remains stronger than normal in present conditions, the red metal would be poised to move higher when the global economy improves. Even after the past month's rally, copper prices remain at historically low levels; as recently as 1995, the price hit a high of more than $1.30 per pound, vs. $0.72 now. However, recently announced supply cutbacks will lead to a tighter market in the next few years, thereby shrinking relatively high copper inventories and subsequently lifting the price - assuming demand increases, of course. Silver prices also remain historically low.

Recently, however, the commercial traders - what's known as the 'smart money' - pulled back their short positions in both silver and copper, a move that tends to anticipate a rally.

Finally, any discussion of the inflation trade isn't complete without a look at the prospect of a weakening U.S. dollar. The threat of inflation only tightens the noose on a currency already suffering the effects of the mammoth U.S. current account deficit. One way to play the greenback's weakness is to go long the Canadian dollar, which also tends to move with commodity prices.

The 'loonie' has rallied more than 2 & 1/2% since early October, a fairly significant move, particularly if you're using options as leverage. Our northern neighbor's currency also does well in an improving economy, but it might benefit additionally from a period of global risk aversion. The reason, quite simply, is that Canada is running a current account surplus of about $12 billion, compared to a U.S. deficit of more than $400 billion. Unlike the United States, Canada doesn't have to worry about attracting foreign capital to plug its financing gap. The euro's recent rally indicates that wariness about the greenback is growing, and buying the loonie allows us to take the same side of the bet without having to invest in a struggling European economy - or even worse, a still-sinking Japanese economy.

In sum, there are many ways to make money in these markets while steering clear of stocks that still carry nosebleed valuations. Why worry, for example, that Main Street will one day catch on to the risk presented by all those underfunded pension plans? Now that we've entered an era in which throwing darts at the stock tables will no longer fund a retirement plan, the return to favor of some good, old-fashioned hard assets may be just beginning.

Sincerely,

Andrew Kashdan,
for The Daily Reckoning

Editor's note: Andrew Kashdan, a top writer at Apogee Research (formerly Grant's Investor), is a regular contributor to John Myers' Oustanding Investments and Resource Trader Alert. Both of these excellent publications cover longs and shorts in the commodities and resource markets. Recent trades in the Resource Trader Alert, for example, have included these gains: 304% on soybean calls (in only 12 days!)…another 125% on coffee…and 145% on the Swiss franc. For more information on trading through these volatile markets, please click here:

The Resource Trader Alert