On July 28, the preliminary second quarter figures for US economic "growth" were announced. The number was 2.5% - 0.5% less than Wall Street had been expecting and less than half of the 5.6% "growth" figure for the first quarter of 2006. There were three initial results. All US stock indices were up with the Dow gaining 119 points. Treasury yields from two to ten years dipped below the 5.00% level with the two year yield rising above (by 0.01%) its ten year counterpart for the first time in nearly two months. And the US Dollar fell as measured by the $US Index (USDX) - down 0.44 to 85.19 points.
Oh yes, and spot future Gold was up $US 2.30 to $US 634.80. The rest of the precious metals were down, Silver by $US 0.02.
Let's first look at the stock market. When a stocks' earnings come in below expectation, that stock is usually savaged with its price dropping - quite often dramatically. But when the entire US economy fails to meet expectations - the second quarter "growth" figure being 0.5% below the consensus of Wall Street analysts - the whole stock market goes up? Of course, the "reason" it went up is that the "low" growth figure reinforced the growing hope that Mr Bernanke's Fed is either done with raising rates or, at worst, will tack on one more 0.25% rise next month and that will be it.
As you know, US consumer spending is universally acknowledged to make up anywhere from two-thirds to three-quarters of US economic "growth". Well, in the second quarter, the increase in consumer spending plummeted from 4.8% to 2.5%. As you know, the term "stagflation" is used to describe a combination of waning economic growth and waxing price inflation. That precisely describes the US economy today. Such an economic situation is amongst the worst possible ones for stock - and bond - markets. Take a look at how they fared in the 1970s. Yet the announcement of a HUGE drop in US economic growth is the occasion for rejoicing on Wall Street, and for higher stock prices.
Truly, we live in strange times. But when the destruction of the infrastructure of an entire nation is labelled "self defense" in Washington DC, then the "strange" reactions going on in US markets at present don't seem so outlandish after all.
Back in the second half of May and the first half of June, global markets of almost all descriptions (including Precious Metals, of course) fell alarmingly. The impetus behind it was a global rush for "liquidity" and the impetus behind that was the growing fear of a worldwide push towards HIGHER interest rates. And indeed, Central Banks all over the world WERE raising their interest rates. The fear wasn't that the global borrowing binge was getting out of control. It was that the global borrowing binge was starting to show up in the wrong place - in the price or raw resources and consumer goods rather than financial "assets" and real estate.
That fear is still very much to the fore in Australia, where the latest official price inflation figures are running at a 4.0% clip. There is universal expectation "down under" that the local Central Bank will raise rates from their current 5.50% when they meet next week. But in the US, the attitude now is to clutch greedily at any evidence of economic slowdown as a signal that the Fed is going to stop raising rates.
And what happens if they do? Well, not to much attention is yet being paid to THAT question. The assumption is that since the Fed has been raising for two years and has "cooled down" the economy, they can stop raising rates now and we can all go back to borrowing and buying up a storm. This assumption has firmed over the past week or two, for the simple reason that thinking about any other possible outcome is to horrifying to even contemplate.
In the US, the last "fountain" of consumer liquidity, the housing bubble, has well and truly burst. Nationwide, unsold housing inventories are now at record highs. This is the preliminary step. The next step will be taken when prices start to fall in an attempt to try to reduce this inventory. And when that happens, the deterioration of the "wealth effect" will be manyfold larger than it was when US stock markets swooned in 2000.
The problem is simple. How are US consumers going to go back to borrowing and buying up a storm when more and more of they are going "underwater" with the only "asset" most of them have, their (mortgaged) house? Less than three months ago, many US "homeowners" were expecting 20% annual increases in the "value" of their houses in perpetuity. The situation is very different now.
Yet the dogma persists that all that is needed is for an end to be made to the two year cycle of official rate rises in the US and all will be well. People will go on borrowing and spending and the US will enjoy that fabled "soft landing". It must be true, the IMF has just come out and cautiously said just that.
In reality, of course, the situation is just the opposite. A halt to Fed rate rises would bring immediate pressure to bear on the US Dollar. A falling US Dollar would inexorably increase the cost of the massive amount of (mainly consumer) goods which the US imports. That would in turn even further blow out the US trade/current account deficit, even if consumers DO buy less. And that would put even more pressure on the US Dollar, and make it even harder for foreign Central Banks to go on buying Treasury assets with their trade surpluses.
Gold is lying patiently in the wings waiting for all this to happen. Once a month, a high official in China comes out in public to urge the Chinese "authorities" to diversify their foreign reserves out of US Dollars and into other currencies, and Gold. Russia, which now has a freely convertible currency, is openly aiming to double the Gold portion of their foreign reserve assets. In terms of Dollar value, the ECB now has more Gold in its official reserves than it does foreign currencies.
As is the case with their "policy" the Middle East, domestic US monetary and fiscal policy is now like a ship without a rudder, unable to maintain any type of steady course and blown about by events over which the "navigators" have steadily decreasing control.
The US economy is slowing sharply while prices rise. The latest "cure all", a moratorium on Fed rate rises, would make the situation not better, but worse. If there is anything which would speed up the final demise of the US Dollar's role as the world's reserve currency, it would be the Fed's refusal to compensate holders of Dollars for the spiralling levels of risk entailed in holding those Dollars. This is what a cessation of rate rises would do.
The last time the US economy faced a situation like the present one (albeit on a MUCH smaller scale) was in the late 1970s. Back then, a Fed Funds rate of 20% plus was required to lure the world back INTO the US Dollar. Today, the comparative rate would be MUCH higher. If the Fed wants to force the rest of the world AWAY from the US Dollar and into other currencies - and Gold - an announcement that they are NOT raising rates at the next FOMC meeting on August 8 would certainly do the trick.
Clearly, the political pressure on them to do just that will be huge. Right now, the Bush Administration is looking no further ahead than November and the mid-term elections. The loss of either House of Congress would be dangerous. The loss of both would be catastrophic. The mess in Iraq, Afghanistan and now Lebanon is bad enough. Add to that a severe slump in the domestic US economy and the recipe becomes almost inevitably politically fatal.
The US economy cannot withstand either higher interest rates or a lower Dollar. If it stops raising rates, the Dollar will fall, and it will end up having to raise rates even faster. If it keeps on raising rates, it will sink the economy as consumer borrowing and spending dries up. That too will lead to a falling Dollar as deficits of all descriptions worsen. And at some point in the fall of the Dollar, interest rates will have to be racheted up to try to prevent a wholesale and worldwide flight from the US currency.
In either scenario, Gold remains the alternative.