Guiding the Dollar into the Abyss

The Federal Reserve came out and pretty much said that we are going to sacrifice the dollar and attempt to inflate equities markets for just a little bit longer.

Is this a surprise?  Not at all, but the inevitable implications of the coming crash of the U.S. dollar have been set in motion by the Federal Reserve’s interest rate decision this Tuesday.

As I view it, any immediate reaction to this news is completely psychological. The rally in gold, the rally in the stock market, and the huge initial sell-off in U.S. dollars are not the results of actual economics happenings.

Going forward, I want to let you know that I write this with extreme passion and strong feelings on the implications of these recent actions by the Federal Reserve.

So the question to be asked now is how big of an impact will this actually have on the market for loanable funds.

Dear reader, you have to remember that the Fed funds rate is just a target rate. As pointed out in The 5 Minute Forecast and other Agora Financial publications, the actual Fed funds rate as been trading under the 5% level for an extended period of time. Albeit, the 50 bp cut of the Federal funds rate brings the actual rate moderately lower in the short term, but it is really a decision that will carry little to no sway in the actual market for loanable funds.

In my opinion, the cut of the discount rate will definitely have a greater effect on the economy and the short-term liquidity situation than the cut of the Federal funds rate.

Why? Well, it’s rather simple, but I need to explain a recent change in the discount rate before I continue on this topic. When the Fed cut the discount rate from 6.25% to 5.75%, it also changed the rules for the actual loans from the discount window.

Before the rate cut in August, the discount rate was used only for overnight lending. The Fed changed the discount window, offering the loans for two-week, 30-day, and 60-day periods of time.

The result of this has been the big investment and commercial banks completely rushing with their credit derivatives, mortgage-backed securities, U.S. Treasuries, and any other forms of commercially backed paper that they could come up with as collateral and receiving enormous amounts of capital in exchange. I am definitely not exaggerating when I say “enormous.”

We have seen these banks taking loans from the discount window at a rate of $2.7 billion per day. In other words, through the discount window alone, the growth in U.S. money supply is running at an annual rate of 50%. Got gold, anyone? Well, if that isn’t enough to convince you, I have a couple of things that might.

Global Implications

These rate cuts, and most likely at least one more before year’s end, will result in the long-coming crash of the U.S. dollar index. As the inevitable is carried out, a complete overhaul in the financial world will ensue. On the winning end of the stick will be anyone who holds gold and gold shares, and on the losing end will be U.S. citizens and everyone else who owns U.S. dollar-denominated assets.

Focusing on the losing side here, more specifically, the folks — like China — who own U.S. dollar-denominated assets have some major powers.

It is fairly common knowledge that China created a sovereign wealth fund in order to create some diversity for China’s forex reserves.

What these dramatic rate cuts tell China is that the Federal Reserve is well on its way to holding the dollar’s hand while the USD index rolls on toward the sub-40 level. This is the equivalent of China losing some $500 billion dollars of its reserves.

But I promise you that the Chinese aren’t stupid. Not only is it completely moronic for China to continue to accumulate U.S. Treasuries, it will also begin to filter more and more of the dollars it already has into the sovereign wealth funds in order to get its hands on as many different commodities as it can. That includes everything from gold and silver to energy and agricultural goods. Oh yeah, you can also put it in writing that the Chinese will use a good portion to build up a formidable military.

Right now, the more important question is not what China is going to do with those dollars, but what the implications of its moves in the forex markets will entail.

I’m not here to preach what everyone else is already saying. Common discussion around the dollar bear watering hole is a collapse in the bond market resulting in much higher interest rates. This seems to be the obvious and most common answer I hear, and I don’t necessarily disagree, but I definitely disagree with how the scenario will play itself out.

The common belief is that when China and other countries such as Japan and the oil-producing nations begin to unload their U.S. Treasuries, extremely high interest rates will ensue.

This will happen eventually, but it will be after the large majority of damage has already been done, and it will be trivial when the bond market actually does collapse. Let me tell you why.

The Federal Reserve will buy every stinking, worthless U.S. Treasury bill that the U.S. government wants it to. The last thing that will happen when the Day of Reckoning comes is a collapse in the bond market. The reason for postponing this kind of financial Armageddon is because when the bond market collapses, the simpletons that are left unaware of our current predicament will finally be onboard and U.S. assets from equities to bonds will be shunned for a very long time to come. I guess you could compare it to a bad case of denial.

The term used to define the Federal Reserve buying government bonds is “monetization.” It will monetize our debt in the worst possible way. This will result in the collapse of the U.S. financial system and the worst hyperinflation we have ever seen in the United States of America.

All you have to do is take a step back and look at the implications of such a notion, but first, a very brief history lesson.

The growth in the U.S. over the last 25 years has not been real growth. It has been the result of asset inflation and debt creation made possible by the U.S. dollar being the reserve currency of the world. We have been able to create money and credit and export our inflation right into the reserve banks of exporting and oil-producing nations.

When the U.S. dollar collapses, our ability to export inflation will no longer be possible. Not only will the nations that have been accumulating U.S. dollars not accumulate them any longer, but they will also unload the dollars that they are currently sitting on. In essence, this is the margin call of the U.S.

Back to the notion of monetizing the debt. With our inability to export our debt, which is just another word for inflation, we will be forced to monetize our debt in order to prevent an immediate collapse of the bond market.

In other words, instead of foreigners financing the hundreds of billions of dollars in deficits, U.S. citizens will be forced to take on the burden. It won’t be in the form of higher taxes, either. Not only are taxes unpopular, the level of debt is unsustainable by U.S. taxpayers alone. The only possible way to pay for our debt will be by monetization and the inflation of the money supply. This will result in hyperinflation, unless you think that the burdens of our budget and trade deficits get under control and problems such as funding Medicare and Social Security are going away.

At this point, everything valued in U.S. dollars will be hyperinflated, including the food you eat, the clothes you wear, and the gas that goes in your car. At the very beginning of the process, equities markets, to the ignorant investor, will appear to experience growth. Obviously, this will be nominal, not real, growth.

The reality is that the stock market just happens to be one of the most popular vehicles in getting those dollars into our economy, and result in a period of short-term strength. As the dollar continues its downward trend, which will begin to occur faster and faster, foreign investment in all U.S. dollar-denominated assets will begin to dry up as their returns are wiped away by an increasingly unfavorable exchange rate. This will be the period of the greatest declines in U.S. equities markets ever seen.

What About Oil?

I have no intentions to scare or intimidate anyone, but realization of these truths is the only way to protect yourself from them. Another aspect that has allowed the U.S. to export its inflation is through the oil market. Approximately 70% of oil in the world is valued in U.S. dollars.

The impact of hyperinflation of the U.S. economy on the oil market will forever change how oil is traded. You can expect the price of oil to rise much faster in U.S. dollars than in other currencies. This will make it extremely uneconomical to trade oil in U.S. dollars and would crush global growth.

The result will be a huge push to trade oil in a more stable currency, such as the euro or yen. All those dollars will be flooded into the forex markets, only worsening an already futile situation.

The Aftermath

The results of the collapsing U.S. dollar will be very dramatic. The U.S. financial markets will go through a complete and utter change.

First and foremost, Wall Street will be the last place global investors will be putting their money. The financial district of New York will seem a ghost town.

Because of the hyperinflation, there will be a huge revaluation of standards. Tax brackets will have to be reconfigured, while small items, such as the amount one can put into a Roth IRA every year, will have to change.

After a failed attempt to save the bond market, interest rates will go through the roof, and business investment will all but cease to exist. The market for loanable funds is so completely manipulated that it will have to go through a complete overhaul. This will come at the cost of the U.S. consumer.

Let’s look at the cup-half-full situation. Where are the opportunities amid such dramatic turmoil?

As the U.S. dollar collapses, a flight to the euro will ensue, if only for the lack of a better alternative. At this point in the argument, gold bugs will be asking, “Is the eurozone a more stable area than the U.S. was 30 or 40 years ago? Does it have more fiscal and monetary restraint than what was shown in the U.S.?”

The fact of the matter is that there are so many U.S. dollars in the world that they will have to find a home somewhere, and I expect many of those individuals and government agencies to look at the euro as a flight to safety.

To answer the question of those gold bugs, I say no to both of their questions. That is the ironic thing here. You can expect the world to go through a similar situation 20-25 years from now, but with the euro, as opposed to the dollar. Now the extremity of the situation depends on the level of global imbalance. I assume that the global economy will take a very important lesson from what is to come, but with every fiat currency in history, the decline is inevitable.

The only true way to truly protect yourself from this situation is to buy physical gold and gold shares. Whatever your preference is as far as precious metal investment vehicles, I would strongly recommend that you accumulate some physical metals.

Dear reader, please take action before it’s too late. When the rush to the exit begins to occur, if you don’t have gold, you won’t be able to get any. There is only a limited supply in this market, and I promise you that a time will come when you will be unable to acquire physical gold. This will be the result of the massive buying by central banks and individual investors. When we hit this wall, we will see the biggest price gains in our favorite yellow metal.

Going forward in a period like this, the only thing you can do is protect yourself, your friends, and your family. The Federal Reserve proved a very valid point, that nobody is watching your back and all you can do is watch out for your own.

Nick Jones

September 20, 2007