Waist Deep in the Big Muddy

With its announcement this week that it will keep interest rates near zero until at least late 2014, the Federal Reserve has put another large crack into the foundations underlying the US dollar. In a misguided attempt to provide clarity and transparency, Ben Bernanke has instead laid out a simple road map for economists and investors to follow. The signposts are easily understood: the Fed will stop at nothing in pursuing its goals of creating phantom GDP growth, holding down unemployment, propping up stock and housing prices, and monetizing government debt. To do so, it will continue to pursue a policy of negative interest rates, while ignoring the collateral damage of unsustainable debt, virulent inflation, misallocated resources and credit, suffering yield-dependent retirees, and a devalued U.S. currency.

Not surprisingly, precious metals and foreign currencies rallied strongly on the news – with gold up more than 4.3% and the Dollar Index down nearly 1.6% in the days following the announcement. The Dollar Index is now down more than 3.5% from its highs in mid-January.

In coming to the momentous decision to extend the Fed’s prior low-rate promises by another 18 months, Bernanke and his cohorts relied on a somber view of the economy that is at odds with the sunnier view presented the night before by President Obama in his State of the Union address. To justify holding rates so low for so long, the Fed is choosing to ignore the fact that CPI inflation is currently running north of 3%. Instead, it has conveniently chosen to look at a hand-picked alternative measure, the chain-weighted core PCE, which comes in just a shade below the Fed’s arbitrary 2% target. How convenient.

After some changes in key membership at the Federal Reserve’s policy-setting Open Markets Committee, in which a few long-time hawks were put out to pasture, the Fed has now established itself at the extreme dovish end of the policy spectrum. Among other central banks around the world, it may now be outflanked only by some very profligate ones in South America and sub-Saharan Africa. Unfortunately, the FOMC has its hands on the wheel of the world’s reserve currency, and therefore its decisions may lead the planet into financial chaos as long as other nations are content to follow the Fed farther and farther into a swamp of liquidity. To paraphrase Pete Seeger’s protest of the escalation of the war in Vietnam, “we are waist deep in the Big Muddy and the damn fool yells ‘press on.'”

The only bright side of the announcement is that it provides precious-metal and foreign-equity investors a fairly good sense that they are on the right side of history. In order to keep rates low, especially at the long end of the yield curve where it matters most, the Fed must continually print money to buy U.S. Treasuries. This will likely push more investors into gold and away from dollar-denominated assets.

As a testament to their own faith in themselves to forecast economic conditions, 6 of the 17 voting FOMC members indicated that they would have preferred to keep rates close to zero at least through 2015. Some even had the audacity to prefer no change until 2016! This comes from the body that couldn’t predict the 2008 financial crisis, even while it stared at them from point-blank range. To look into a completely uncertain future and determine that negative interest rates can persist for another four years without igniting inflation is to me the height of economic insanity. Sadly, the inmates have the keys to the institution.

The lunacy persists in the rest of the government as well, with Congress and the White House still failing to address our nation’s long-term debt issues. The Fed’s commitment gives these politicians a “Get Out of Jail Free” card to continue avoiding responsibility. The deficits will be monetized, so no real efforts need be made to cut spending or raise taxes on middle-class Americans. Central to these plans is the assumption that the rest of the world will happily park their savings in U.S. dollars forever. If the latest announcement does not disabuse the world of this notion, I don’t know what will.

As long as interest rates remain far below the rate of inflation, the U.S. economy will fail to equitably restructure itself for a lasting recovery. As a secondary effect, U.S. savers will likely continue to suffer from a lack of yield and a weakening currency. In the end, the collapse of the U.S. economy will be that much more spectacular due to the great lengths we have gone to postpone it.

The Dollar’s Lucky Streak

Recent U.S. economic data, such as the modest drop in the unemployment rate and the massive expansion of consumer credit, have suggested that the American economy is finally recovering. Opposite conclusions are being thrown at Europe, where many are convinced that recession is returning. Not surprisingly then, the dollar is currently hitting a multi-year high against the euro. The strength of the dollar itself is often held up as one of the major proof points that the U.S. economy is “improving.” But the data points that I believe really matter continue to suggest an economy on life support. I believe that the dollar is rising for reasons that have nothing to do with America’s economic health.

The ongoing sovereign debt crisis in Europe is unquestionably the center ring in the current economic circus. Given the difficulty of setting policy across borders and national interests, the negotiations in Europe have been messy, acrimonious, inconclusive, and conducted under the glaring lights of global media scrutiny. The action has diverted attention away from America’s problems, which in many ways are even greater than those in Europe. In contrast, America’s ability to print the world’s currency at will, and the nearly seamless agreement of policy between the Administration and the Federal Reserve, means that the United States has been able to virtually ignore the issues that Europe has been forced to confront. This relative calm has been mistaken for strength, and the dollar has beckoned as the ultimate safe haven currency.

The fact that the dollar is perceived as a safe haven acts as a self–fulfilling prophesy. Investors flee the euro and pile into dollars. The dollar then rises to reflect the demand. The increase validates the decision to buy in the first place, and the rising dollar then attracts even more buyers looking to profit from its appreciation. It’s a nice ride while it lasts.

Most “safe haven” dollar purchases are directed toward U.S. Treasuries. As a result U.S. interest rates are far lower than they would otherwise be without this inflow of spooked liquidity. But objectively speaking, the U.S. and Italy, for instance, have very similar national debt profiles. Yet interest rates in Washington are currently 600 basis points lower than they are in Rome. This means that Americans can borrow and spend much more. The result of all this extra debt financed consumption is a boost in employment and GDP. The positive economic impact makes the dollar even more attractive, thereby perpetuating the cycle.

If rates in Italy (or Spain for that matter) were as low now as they were two years ago, those countries would not be experiencing the problems they are today. Their borrowing costs would never have risen and their budgets would still be manageable. Similarly, higher interest rates in the U.S. would completely take the shine out of our economy. Imagine what would happen here if rates were just 200 basis points higher, let alone 600? U.S. consumers, homeowners, corporations, and governments are particularly dependent on cheap financing. As bad as things are in Europe, they would be even worse here.

In other words, contrary to popular belief, the problems in Europe are helping, not hindering, the U.S economy – at least in the short-term. Over the long term, borrowing and spending more money to finance consumption and government red ink will not help the U.S. economy achieve a sustainable balance. If safe haven flows were to reverse (which could result from an improvement in Europe), the dollar would fall, interest rates and consumer prices would rise, and the U.S. economy would be right back in recession. The only “good news” is that such a positive development in Europe appears unlikely in the short-run.

All self-perpetuating virtuous cycles are vulnerable to a sudden break in the positive feedback loop. When reality rears its ugly head, and the spell breaks, the reverses can be vicious. It happened with dot com stocks, it happened with real estate, and I believe it will happen with the dollar and Treasuries. Even if Europe does not resolve its problems, the day of reckoning will still eventually arrive. The unfortunate truth is that the longer it takes, the worse it will be, as we will have that much more debt to reckon with.

The End of the Gold Rush?

By Peter Schiff

For such a wonderful year for precious metals investors, the final calendar quarter left little to celebrate. Just as people now take for granted that their phones will also take pictures, play music, and surf the internet, many investors have come to expect gold and silver to move up in a straight line.

In fact, in a recent CNBC interview one analyst claimed that gold’s recent correction proves that it is not really a safe haven. In truth, such a statement merely proves how little some analysts know about markets.

However much the fundamentals may be on your side, there are always mitigating factors that affect price movement. In the case of gold and silver, the temporary resurgence of the dollar versus other fiat currencies alternatives has been the dominant factor – but even that isn’t the whole story.