The Death of the US Dollar

The Death of the US Dollar London, England - Melbourne, Australia Wednesday, 19 September 2007

In This Issue: Fed cuts rates Gold rallies Aussie housing market profoundly unaffordable

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From Dan Denning at the Old Hat Factory:

--Bang bang. Or should we say, "cut, cut". Either way, the US dollar's dead.

--We were two-thirds right in our predictions yesterday. The Fed cut both the funds rate and the discount rate by 50 basis points—exactly as we said they would. The cut in the Fed Funds rate to 4.75% is the first in four years and represents a new, disreputable phase in the shabby career of the US dollar. The discount rate—what the Fed charges banks to borrow money—was also lowered 50 basis points to 5.25%.

--What now?

--The US stock market rallied, with the Dow Industrials up 335 points for the day and the broader S&P adding on 43 points. Aussie stocks are up early too, as is the Aussie dollar (nearly two cents). But the telling gains were in oil and gold.

--Light sweet NYMEX crude closed up 94 cents and 1.17% for the day. It now trades at US$81.51—an all time high. Keep in mind that the spot price of oil was US$55.10 on January 17th of this year. If you're scoring at home, that's a 48% increase in price from the 52-week low. Oil's strength is the dollar's weakness.

--"Ultimately we see the funds rate at at least 3.75% and maybe lower. The Fed's path ahead is clear," said PIMCO's Bill Gross in an interview on Bloomberg TV. Gross mentioned what we cited yesterday. The Fed's real concern is a recession—thus the double barrelled rate cut.

--If rates go even lower—and the wave of re-setting subprimes ensures the Fed will have plenty to worry about—how much higher might the oil price go? And will it prompt OPEC to begin pricing oil in a currency that's not falling apart faster than a leper in a dodgem car?

--There are probably more questions than answers today, especially about oil. The cost of production for a barrel of Saudi crude is around US$7, if we recall correctly. For lower grade Russian crude buried under Siberian perma-frost, it's closer to US$12. Either number is a long way from US$81. Is oil part of the melt-up bubble too? Hmmn.

--Mike Rothman, the former Chief Energy strategist at Merrill Lynch, told US financial weekly Barron's over the weekend that he reckoned oil is headed to US$45. He says new supply is coming along, demand growth has slowed, and high prices have prompted two predictable marketplace reactions, substitution and conservation.

--"I don't think people are aware that demand has really fallen off so much," Rothman told Barron's. "The rate of global oil-demand growth has really slowed pretty dramatically since '04. I've had to make a large downward revision for the second quarter, and it looks like I am going to have to make another one for the third quarter. A chart of the OECD [Organization for Economic Cooperation and Development] countries shows demand growth has been negative, with the exception of a small gain in the second quarter; that's the first time since 2005 that there's been some growth in demand, and it was modest. That's the worst showing since the '80-'82 recession."

--Did he mention recession? With Japan headed toward recession and America already in one, you'd expect both to be bearish for oil demand. And then there's that bit about high prices being the cure for high prices. If US$80 oil doesn't take the edge off demand, what will it take, US$100 oil?

--Leaving aside the declining dollar's influence on oil prices, it's probably a good time for energy bulls to seriously consider the chances of a pullback in oil prices—even if oil and energy stocks are still in a long-term bull market. For the Aussie energy sector, Woodside's US$55 billion deal with China is about as good a news item as you can get.

--Woodside is trading just below its 52-week high of US$47.89. It wouldn't surprise us to see Woodside make a new high 52-week high today on the back of the rate cut and the move in oil. And after that…a correction.

--What's with all the predictions and forecasts anyway? We're not making them because it's fun to do. On the contrary. Making a prediction rarely does you any good—unless you're making money on it by trading it, which we are not doing at the Old Hat Factory. Instead, we're trying to figure out the current inter-market relationships between asset classes like cash, gold, stocks, bonds, and oil.

--Those relationships are never cut and dried. But they used to be much clearer than they are today. US stocks, for example, absolutely love the rate cuts. But if you're investing in US stocks from abroad, the dollar's morose reaction means what you'd gain from the rise of the Dow, you'd give back with the decline of the dollar.

--Again, it's not as cut and dried as we describe. But what we're getting at is that with so many variables affecting your total return as an investor, it's best to break Occam's razor and keep it simple. That means seriously considering gold's role in a fiat currency world gone mad.

--Gold for December delivery was up US$11.70 after the Fed broadcast its intent to sacrifice the dollar on behalf of the housing market. We realised the significance this morning when we noted that the futures price—at US$735—is at 27-year high. That's longer than most of our co- workers have been alive.

--Spot gold is at US$723. And unlike oil, we don't expect the high gold price to lead to lower demand. Just the opposite.

--The more the Fed cuts interest rates, the higher gold will go. As our friend Porter Stansberry put it, "The Fed will cut, and it will continue to cut, because its mandate is to protect the banks (yes… I know… its legal mandate is officially "price stability," ha, ha, ha… I'm talking about its actual mandate, though). Having made hundreds of billions in bad loans, the banks – once again – need to be bailed out."

--"Like geese that feel the winter coming even when it's still warm outside," Porter continues, "wise investors have watched the credit bubble build and have flown to gold. Anyone with any sense has long since bought gold – as we've been preaching regularly since 2003. Soon, the kind of investors who like to chase performance (a short-lived, but sometimes influential group) will jump into gold, too. That's when you'll know it's time to take some off the table…"

--It's probably not time yet, though. Here in Australia, the gold sector was up nearly 2% yesterday. Major producers Newcrest (ASX:NCM), Sinogold (ASX:SGX) and Lihir (ASX:LGL) are all up smartly today. Smaller gold stocks will likely soon follow.

--In the big picture, you're already seeing Aussie dollar strength, and a rising gold price in Aussie dollars too. Economically, however, the same fundamental problems that have laid America's economy low also afflict Australia's economy: debt, globalisation, and dependence on rising housing prices. Though the resource story is bullish, the debt story is not.

-- "Economist Steve Keen warned that mortgage obligations in Australia were set to reach crisis point in less than two years, while a study by JP Morgan found that about 600,000 households, or 8 per cent of the market, were likely to experience at least mild mortgage stress by the end of this year," writes James McCullough in today's Courier Mail.

--It's not so much that the American subprime crisis will hit Aussie banks—although that appears to be a possibility in few cases. These things are as never as isolated or "contained" as the authorities would like you to believe. The real problem is that Australians have been using debt to live above their means.

--There are several explanations. Maybe it's because wages haven't kept up with inflation. Maybe it's inflation in expectations. With so many visible signs of wealth, the temptation to feel wealthy by surrounding yourself with new things (including a home) is strong, even if you can't afford them. All you have to do is reach into your back pocket and slap down some plastic. Maybe the entire financial system is rigged to put people in debt and keep them there, making the banks rich.

--Whichever explanation you prefer, there are certain realities that don't change. Homeownership, though a nice national goal, is always a highly individual choice. More importantly, it's a straight financial decision. It comes down to simple math: can you afford the mortgage payment?

--With rising house prices, many people have been seduced into the idea of getting rich quickly through property. But affordability has not really improved. It's gotten worse, in fact. Only the availability of easy credit has kept people in the game. But this isn't a game most people should want to play—not that we are in the business of telling people what they should want. Perhaps we should rephrase: accumulating debt to buy assets that fluctuate in market value is a sucker's game. Most people lose at it.

--As one reader put it in a comment over at our website (www.dailyreckoning.com.au):

"For a year now I've been smacking my forehead over the Australian media's ostrich approach to the fact that most people here cannot afford the houses they live in.

"No wonder so many Joes here fell for it, considering how ill-informed they are by the dailies. Going by those, you'd still think the global credit bubble deflating is just "US sub-prime". "Solvency" might not even cross your mind.

"Now that the inevitable credit fiasco is happening, the first glimmerings of awareness are hitting the papers. "You mean Aussie Joe really can't afford a US$320K mortgage on a wage of US$50K and change?!!?" Like it's that surprising to anyone who has eyes in their head and a lick o' common sense.

"I'd love to see an expose - I know, won't be done until more Aussies are bloggers - on how much the mainstream media here is reliant on Real Estate advertising."

--You should be able to find a breakdown in the composition of revenues for media companies in their annual reports. We'll have a look this afternoon and report back what we find tomorrow. Until then…

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And now over to Bill Bonner:

We got word last week that our new book – written with co-author Lila Rajiva – Mobs, Messiahs, and Markets , reached the New York Times bestseller list.

Many thanks to all you Dear Readers who bought it. We earn about 30 cents, after tax, on each one that is sold. Not much. But, hey, every penny counts.

Besides, we're already getting in the spirit of the New Age. That is, along with other baby boomers, we're beginning to downsize...to simplify...to make do with less. Last night, for example, we put on a tuxedo to attend a fancy dinner. We found that we had forgotten to bring our cufflinks. We didn't really want to invest in a new pair of cufflinks, so we went to the local hardware store and bought a couple small machine-thread bolts, with nuts and washers, for less than 25 cents.

Not only were they ingenuous, they were actually rather cool. At least we thought so. We proudly showed them to Elizabeth; she wasn't impressed. She failed to see the funky elegance in them. She thought they should have stayed in the tool-chest...

But we are here to offer advice and opinions to our Dear Readers...so we will continue to pass along helpful hints and suggestions in keeping with the new downscaling, money-saving zeitgeist of the time.

Alan Greenspan came out with his own book on Monday – The Age of Turbulence. Not a very good title, in our opinion. Still, it is sure to knock our own tome off the shelves. Everyone wants to know what the Maestro was really thinking.

According to Bob Woodward's review in the Washington Post, the Fed chief liked Bill Clinton. He thought the man from Hope did a good job of holding down federal spending. By contrast, he has harsh words of criticism for the Republicans:

"My biggest frustration remained the president's unwillingness to wield his veto against out-of-control spending," Greenspan writes. "Not exercising the veto power became a hallmark of the Bush presidency... To my mind, Bush's collaborate-don't-confront approach was a major mistake."

Greenspan seems to see the Republicans as we see them; that is, as wimpy, stupid, opportunists. They might as well be Democrats! He says they deserved to lose control of the House and Senate last year: "The Republicans in Congress lost their way," Greenspan writes. "They swapped principle for power. They ended up with neither."

Of Republican leaders J. Dennis Hastert and Tom DeLay, who resigned after being indicted for violating campaign finance laws, Greenspan notes:

"House Speaker Hastert and House majority leader Tom DeLay seemed readily inclined to loosen the federal purse strings any time it might help add a few more seats to the Republican majority...I don't think the Democrats won. It was the Republicans who lost. The Democrats came to power in the Congress because they were the only party left standing."

He goes on to criticise Vice President Dick Cheney, who once remarked that, "Reagan proved deficits don't matter."

Of course, "deficits DO matter," says Greenspan.

We don't know whether anything in Greenspan's memoir will come as news. We doubt it will save Greenspan's reputation from the reappraisal it deserves. Deficits do matter, and the former Fed chairman is probably responsible for more deficits than any human being that ever lived. His emergency-low-interest rates made the whole world deficit friendly.

Businesses ran deficits...and weakened their balance sheets. Greenspan blames Bush for the US government deficits...but it was the Fed that helped make deficits so easy to finance. Individuals, too, ran deficits in their household accounts. Now, those deficits have hardened into iron-cold debt...

Meanwhile, "India is still a buy," says our Bombay colleague, Ajit Dayal. "It went down hard in 2002. Everyone was running scared. But we said it was a buying opportunity. We were right. The index recovered...and now it's higher than ever. And now people ask us if it isn't a good time to sell out. We don't think so. There could be a liquidity crunch in India, but the economy is growing...and that isn't going to change. India is a very good long-term buy."

[Editor's Note: Bill Bonner & Lila Rajiva's new book, Mobs, Messiahs and Markets, is now available in Australia from The Educated Investor. Order here for a 15% discount.]