There is by now almost universal expectation that when the FOMC meets on May 16, they will raise the Fed Funds rate by 0.50% to 6.50%. So far, some "benign" economic numbers, including a PPI drop of 0.3% ("core" PPI was up 0.1%), has done nothing to shake that conviction. Well, if the Fed DOES raise by 0.5% on May 16, they will be breaking a quite long-standing habit.
(Posted here on May 12)
The Fed broke the habit, it raised by 0.50%. And there were no hints dropped that this was to be the "last rate rise". The FOMC announcement contained no declaration of "bias" in any particular direction.
On the markets, the major U.S. stock indexes surged up to May 16, and then gave it all back again by the end of the week. In fact, all stock markets everywhere were giving it back by the end of the week. The Japanese market, for example, has slumped almost 4000 points in the last five weeks. It was at a firm year 2000 low, more than 400 points down on the day, in mid-session trading on May 19 before a rescue act was laid on and the Nikkei closed for the week down a mere 173 points.
The Treasury market was the mirror image of the stock market. Yields rose, then fell, especially at the short end, where the three-month bills ended the week yielding 5.87%.
And commodities continued to rise, even in terms of the rampant Dollar. Oil regained the $US 30 level. The CRB index has risen almost 6% in the last three weeks. Even Platinum and Palladium soared. Gold (and Silver)? Well, they just hung in there. They didn't really do much of anything.
Clearly, financial markets are getting to be more and more dangerous places. And just as clearly, investors both inside and outside the U.S. are getting more and more rattled. Day trading volume has collapsed on the U.S. stock market. Margin volume is way down. In nations outside the U.S. (Australia being a notable example), consumer spending has hit a brick wall. People are getting nervous out there. And whenever people get nervous, they start looking around for somewhere "safe" to park at least some of their money.
The problem facing most people in the world is that their own local currency does not look like a particularly "safe" place to park their wealth right now. Europeans have seen their currencies (and the Euro itself) sag badly against the Dollar and rates on offer in Europe are much less than U.S. rates. Asia is starting to look uncomfortably like it did about three years ago, on the eve of the Asian crisis. The Indonesian Rupiah has crashed. Thailand is busily denying any plans to institute currency exchange controls. The exceptions in Asia are China and Hong Kong, whose currencies are still tied to the Dollar, and Japan, which has been in economic bust mode for more than ten years.
The Big habit we refer to above is the ingrained tendency to look to the Dollar and more specifically to interest-bearing Dollar instruments as THE place to go to protect capital. For at least the past five years, the primary lure of the Dollar was as a necessary way station on the path to the U.S. stock market, where riches beyond the dreams of avarice awaited. But now, the lure of the U.S. stock market is waning fast. What is NOT waning, not yet anyway, is the lure of the Dollar as a place to protect what one has.
The U.S. MUST continue to attract foreign capital. It has no savings. Its people continue to live beyond their immediate means, trusting the stock market to provide. Thus, the U.S. MUST continue to be a magnet for foreign capital. With prospects for capital gains dwindling - see the recent performance of the U.S. stock and bond markets - the prospect for at least a solid rate of return in a SAFE investment must be maintained. That means HIGHER interest rates.
(Posted here on May 12)
In the early 1980s, when U.S. prime rates exceeded 20%, the most important effect was to lure people back to the Dollar. They had been abandoning it for Gold and real goods throughout the late 1970s.
Now, the U.S. needs the rest of the world's capital to finance its insatiable appetite for imports, and to support its domestic investment markets. It does not need to lure anyone back to the Dollar, it merely needs to make sure that they stay there. As long as the Dollar is strong, and U.S. interest rates are (comparatively) high, the lure will continue to work, and the long-standing habit of heading for the Dollar in times of financial stress will not be broken.
That is why the sudden surge in the Dollar is so critical, and so dangerous. It is critical because it has enabled the U.S. to go on attracting the capital it must have. It is dangerous because the Dollar's financial "magnetism" will only last as long as it continues.
In the face of this Dollar surge, Gold has held up very well indeed. It remains, as it has always remained, THE alternative to fiat debt-based paper currency. As long as the Dollar is perceived to be safe, it will stay waiting in the wings. The moment that the world's "confidence" in the Dollar begins to falter, it will emerge.
The situation is now as simple as that