Why the US Dollar Should Look Out Below

Well, who would ever have guessed even a month ago that the country once considered the great global bastion of capitalism would embrace socialism with open arms … and without a shot being fired or a riot in the streets?

The Bush administration is well on its way to acquiring unchecked power from Congress to buy $700 billion in bad mortgage investments from financial companies. This plan aims to dodge a credit freeze that could immobilize the financial system and the world’s largest economy (which sounds like a great idea, doesn’t it?) but all sales are final: the bill would prevent courts from reviewing actions taken under Treasury authority.

Whoops, handing over dictatorial power has never worked well in a democracy, has it? The government, specifically the Treasury and its Secretary Henry Paulson, is seeking absolute authority to buy home loans, mortgage-backed securities, commercial mortgage-related assets and potentially “other assets, as deemed necessary to effectively stabilize financial markets” after consultation with the Federal Reserve chairman.

What’s more, the Treasury would have further Fed-approved discretion to make even non-U.S. financial institutions eligible for a rescue. Truth really is stranger than fiction, folks! The government is going to use your money to bail out Wall Street and its friends around the world too.

Your tax dollars, and your national currency, are going to the wall to protect banks from their own bad decisions and you’re not even allowed to question the wisdom of the financial authorities who failed to anticipate and regulate the problem in the first place.

Totalitarian Financing, Enter Stage Right Please

Paulson claims that dictatorial powers are required to ensure no time is wasted in “rescuing” the markets as he hires managers, writes and signs contracts and issues U.S. mortgage finance regulations. However, we’re pretty skeptical that any one institution is going to get it right and save the world. A little thing called central planning (under the guise of Communism) didn’t work out so well throughout history … so what makes Paulson think he’s going to do any better?

There have been claims made by some parties that this is actually a terrific deal as the Treasury could potentially make some money if everything works out OK. Our view is: if this was such a great deal then why didn’t a large private consortium form to finance this deal themselves? After all, there are large pools of offshore capital which could afford an investment of this magnitude.

But since no one did step up, you can safely say that anyone with sufficient funds took one look at this plan and ran away like their hair was on fire. Let’s face it: when has any large financial investment made by the government worked out well?

Is No RTC

The government once tried using a Resolution Trust Corporation [RTC] during the Savings & Loan crisis in the early 1990s. The RTC was intended to take over insolvent banks and sell off their assets, but there’s one critical difference between the RTC and the bailout plan: the RTC worked with real assts that were relatively easy to value.

Today’s plan is dealing with complex derivatives that are impossible to value as they do not close until expiry or until an obscure trigger factor comes into play. Due to the highly unregulated nature of these particular derivatives, no one really knows what the risks are. The counterparties may or may not be known, there may be other layers of derivatives based on the first layer (and then interlinked in a variety of ways almost impossible to fully value), many of these derivatives will have no real assets upon which to draw in the event of losses … and so on and so forth.

Basically, the Treasury is trying to stick a bomb into a garbage can and hope the explosion isn’t strong enough to level the neighborhood.

The Risk to Your Dollar

So why is the US dollar at risk? Via this plan, the national debt ceiling will be raised to $11.315 trillion from $10.615 trillion (that’s a 6.2% increase in one fell swoop!) … and new expenses costing more than the combined annual budgets of the Departments of Defense, Education and Health and Human Services are about to become reality.

Even if there’s more deflation due to financial asset wipeouts (this characterized the start of the Great Depression), there’s one thing the Fed does well. All these extra expenses and the dread clouds of risk uncertainty are going to push the Fed to print its way out of trouble. After all, a big debt can become a less big debt when the dollars in which it is owed are worth less (or should that be worthless?) …

It’s hard to believe that the dollar can be considered a safe haven any longer after these unprecedented actions by the Treasury. Dollar devaluation, here we come!

As evidence, let’s look at how some of the more important commodities reacted to last week’s news …

Crude Oil shot back over $100 with a vengeance, punching through two of three moving averages in a mere three days with the third one on the verge of falling already. Note how the RSI dropped neatly to give the buy signal beforehand. Oil should rocket up to $120 before experiencing any significant resistance according to this chart.

Copper has been relatively stable, but it’s getting ready to move too. It broke through two of three moving average, and look at the strong divergence between a higher MACD “valley” in August and the lower price right now. Even RSI is showing divergence as well, meaning that this industrial necessity is going to head up shortly.

And just like crude oil, the dollar’s arch-enemy Gold rocketed violently last week. It shattered all three moving averages in one day and looks poised for further furious gains. Gold is always the safe haven of choice when paper assets look shaky and the price action over the last three days has been no exception. Notice the MACD divergence between its August low and most recent “valley” – someone was buying gold on the sly before the brown stuff hit the fan, just in case! So far that bet’s paid off handsomely for them and there should be further good profits ahead.

There has been a theory that commodities became oversold when the US dollar temporarily became a safe haven during the Russia/Georgia crisis, which seems as likely an explanation as any to us. The prices certainly dropped to lower prices than we expected!

But they seem poised to resume their bullish upward trends now, as we’ve highlighted in this issue of Charts of the Week.

Just for reference, here’s how gold has looked over the last five years:

From $368/oz to $1002 in five years – now that’s a bull market. Based on recent history, we expect gold to be challenging its recent $1000/oz high before much longer, and subsequently shoot to a new five year high. When a chart is bullish, the trend is your friend!

And please do be safe with your money, for as per the ancient Chinese curse, we live in all-too-interesting financial times right now.

Good investing,

Nick Thomas
Analyst, Oxbury Research