Oct. 13(Bloomberg) – France, Germany, Spain, the Netherlands and Austria committed 1.3 trillion euros ($1.8 trillion) to guarantee bank loans and take stakes in lenders, racing to prevent the collapse of the financial system

With this $1.8 trillion, and the most recent rumors of a $250 billion bank stake funded by the U.S. Treasury, G-7 economies will have flooded the global banking system with over $10 trillion worth of currency.

I’ve been a proclaimed dollar bear for some time, and this changes nothing except how we look at or define the title.  Many consider a dollar bear market one where the value of the dollar declines relative to the other currencies.  That is fine, and I wrote last week that changes in the value of a currency relative to another currency is simply the difference in the money supply growths of the two currencies, but financial markets are changing fast.

Bailouts Soon to Drive Currency Markets

Going forward, we will no longer be able to define the dollar’s weakness by its exchange rate with the Euro, Yen, or any other foreign currency.  Instead, we have to look at their purchasing power relative to tangible assets.  The exact reason is the quote from the Bloomberg article.  This is a GLOBAL race to inflate, and the near term fundamental drivers of forex markets are as follows: the amount of short term debt liabilities that will need to be rolled over and leverage ratios of the countries banking system.

You see, governing bodies and monetary authorities have to guarantee their banking system.  They have no choice.  Whether they do it Britain style with an all out guarantee on banking deposits (soon to be a 100% guarantee in the U.S.), or whether it’s simply nationalization of the banking system, governments will back up their financial systems.  The alternative is simply not an option.

In order to guarantee and/or bailout a financial system, money must be created and injected into the banking system.  By defining the amount of short term debt liabilities and banking system leverage ratios, we can define, more or less, how much money is going to need, relative to other nations, to be created in order to bail that nation out.  This will be the ONE DRIVING FACTOR in forex markets for the next phase of this financial crisis.

Please don’t get me wrong.  In the whole scheme of things, the dollar demise is still well in tact.  The fundamental issues we facing the value of the U.S. dollar are still there, and in a way, unique to the U.S. dollar.  These issues will be covered in future editions of B&B.

Bear Market Rallies Are Just That

This brings us right into the next issue.  Throughout the systematic decline of equities markets, cash and government debt has been king.  So much so, in fact, that U.S. treasuries were recording some of their lowest yields in history. 
This is a trade that will DIE.  I believe that the long bonds trade will explode, and getting short the bonds will be one of the greatest trading opportunities of our life time (along with long gold).  I can tell you exactly how this scenario is going to play out.

Equities markets have, or are in the process of forming an interim bottom.  This is not a bold claim as every analyst and their mother have been claiming this for a week or more.  I think I’ve actually heard the word capitulation more times in the last 7 days than I have in the rest of my life combined.

But contrary to what you hear on CNBC, this is not the end of the bear market, and this will not be the absolute bottom.  Historically, bear markets last 12-14 years, not 12-14 months.  What we must understand is that there are sizeable rallies in bear markets.  The bear market that lasted from 1968-1982 had three rallies of 40% or more.  We are about to experience one of those rallies.

Like in the 1970s, those rallies ended, and markets made new lows.  WHEN, not if, that occurs here in the U.S., investors will be forced to make some decisions.  Next time cash and bonds won’t be king.

The Golden Rule

You see, the same problems that will drive down our stock markets WILL RESULT IN HIGHER INTEREST RATES AND MASSIVE INFLATION.  The ONLY direction for interest rates is higher.  Please note that I’m not talking about official rates set by monetary authorities.  They will be slashed to near zero levels, but the Fed will not be able to control our multi trillion dollar economy by manipulating short term interest rates.

With equities crashing, inflation running rampart, and interest rates going ballistic, investors will shun government debt, and I don’t care if it’s a 10- year U.S. bond, German Bund, or U.K. Guilt.  Being short these markets at the right time will result in truly fantastic returns.

Reading between the lines here, the one market that will be left for investment will be commodities.  Listen, for the last three years I’ve been saying there will be some notable events that will unleash commodities markets.  The events are based on the notion of commodities like gold holding two main purposes: a dollar hedge and flight to safety

The first of those events recently occurred.  I’m referring to the collapse of the Euro.  The Euro has been a prominent dollar hedge up until now.  That will no longer hold as Trichet and his cohorts at the ECB began flooding their financial systems with liquidity.  This resulted in individuals who hedged their dollar with Euros needing to find another option…got gold?

The second event, I’m sure you’ve figured out by now, has to do with gold’s substitutes as a flight to security.  This is obviously the bonds and cash markets.  When investors realize that bonds and cash are no longer a true flight to safety, we will see some real fireworks in the gold market.  As previously mentioned, this will most likely occur during the next down turn of the equities markets.  Please remember that the size of the bond market COMPLETELY DWARFS the precious metals market.  These markets will have a hard time absorbing the liquidity and massive volatility will ensue.

What we are about to be faced with is the Golden Rule, but it’s not the rule you were taught growing up.  My Golden Rule is very simple: he who has the gold rules.  This was the very first thing my mentor ever told me.  It has been true since the time of pharaohs, and will it will stand true long after we depart from this world.

Nicholas Jones
Analyst, Oxbury Research