If you would have told the "economists/analysts" on CNBC or Bloomberg six months ago that the next interest rate move by the Fed would be down, you would have most likely been laughed at.  You see, market capitulation in any market is often relative. For many, just when you feel comfortable with a trading range, or trend, it changes.  When we slashed rates down to 2%, many individuals (even the doves), said that’s more than enough. 

A couple bank failures, takeovers, bankruptcies, and bail out later and the markets were screaming for a rate cut.  This time it was a cry for a globally coordinated cut, and that’s what markets got.  It happened to be to the tune of a 50 BP move by the Fed, ECB, BoE, BoC, and the Swedish Riksbank.

Trichet has lied as all central authorities do so seamlessly.  He stood tall with his hawkish rhetoric before the urge to inflate took over.  Many believed him.  I did not.  Regardless, I’ve mentioned on several occasions that the trend for monetary authorities around the world would be to cut rates.  The race to inflate was on.

Race to Inflate

For several reasons, the largest being the dire need for credit by the G-7 economies in order to survive, it is impossible for central banks to raise rates.  Simply put, the result would be deflation that dwarfs the 1930s.

Up until now, the dollar has taken the brunt of the beating.  What we are quickly learning is that Europe and the rest of the world is sitting on more bad paper than they are letting on.  Euro LIBOR and other lending rates are through the roof as their credit markets have locked up as well.

How will they respond?  They will do exactly what we are doing here in the U.S., but on a smaller scale.  The BoE is discussing a bail out to the tune of $88 billion.  Germany has recently guaranteed all bank deposits, an action already undertaken by U.K. regulators.  Last, but most definitely not least, is the direct AIG bailout style intervention that began two weeks ago.

In short, the ECB, BoE, and the rest of the world will attempt to inflate their way out of this mess.

Euro or Gold

This leads us right into an issue that is overdue for discussion.  How should we hedge the falling dollar: gold or the Euro?  The content of this article leading up to this question provides both my opinion and the obvious answer.

Gold has been, and will always continue to be the best hedge towards any falling currency.  It’s really a basic notion.  As an investment, the rise in value of one currency over another simply equates to the differences in inflation as defined by money supply growth.  There are other extraneous factors, but this is theory put to practice (the only acceptable type of theory).

Let’s say the U.S. is growing its monetary base (M3) by 15% per annum.  This could come via Fed auctions, money used in bail outs, Fed intervention in commercial debt markets, etc.  It is all money created by the printing press or growth in credit. 

On the other hand, the Euro zone is doing the same thing on a smaller scale.  The main difference in the amount of excess that was created is simply the dollar being the reserve currency of the world.  This created an insatiable demand for dollars allowing our imbalances to grow enormously.

Understanding that, let’s say that Euro zone M3 growth is 10%.  Because of the differences in the money supply growth, I would fully expect the Euro to gain 5% in value compared to the dollar.  On the other hand gold will gain 15% against the dollar.

You see, gold is the only asset left in the world that isn’t somebody else’s liability.  That was a quality that was overlooked and underappreciated for a long time until recently. 

All in all, this doesn’t mean that the correlation coefficient between gold and the dollar will be exactly negative one at all times.  There are times of panic, hedge fund liquidation, buying/selling by monetary authorities, etc. that affect these values.

In the long run, it’s all irrelevant noise.  The price of gold WILL show exactly the money supply growth, and right now money supply growth is GROWING EXPONENTIALLY. Got gold?

Nicholas Jones
Analyst, Oxbury Research