U.S. Dollar Retreating Against Commodities

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 met in America last Tuesday. Economists surveyed by Bloomberg expected the U.S. central bank to cut short-term rates to just twenty-five basis points, and it did. That puts 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 is 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).

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. A stronger Aussie dollar might hurt Aussie investors in this respect—unless the U.S. dollar price of gold rises faster than the AUD/USD.

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

December 24, 2008

The Daily Reckoning