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Higher interest rates won''t help dollar when they collapse the U.S. economy
1994 REVISITED
By Eric J. Fry
DailyReckoning.com
Thursday, March 24, 2005
http://www.dailyreckoning.com/RudeAwake/Articles/RA032405.html
Two days ago, your New York editor guessed that Villanova might win
the NCAA championships and that gold might soon resume its rally. The
good news is that Villanova still has a chance. ...
The bad news is that Alan Greenspan thrust a semantic stake through
the heart of the gold market .. .or so it has seemed since last
Tuesday.
The chairman's quarter-point rate hike -- and his accompanying
verbiage -- stunned the gold market, while also rocking most other
financial markets. But despite gold's near-death experience this
week, we suspect it will rise again ... along with most other
commodity markets.
The commodity bull market might be out of breath, but we doubt it
will suffocate.
Last Tuesday, around 2:15 Eastern Time, the benign American financial
environment suddenly assumed a very menacing demeanor. At that very
moment, Chairman Greenspan hiked short-term interest rates one-
quarter point to 2.75 percent. Within minutes, investors rushed to
sell stocks, bonds, oil, gold, and every other financial asset that
wasn't bolted to the floor. By day's end, the Dow had dropped nearly
100 points, crude oil had slipped nearly two dollars from its high
and gold had tumbled nearly 10 dollars.
The Fed's itty-bitty adjustment to its itty-bitty interest rate
should not have produced such a mess. After all, nearly every
economist and investor in the land had anticipated this exact move.
Apparently, however, all these economists and investors were not
prepared to learn that the chairman considered inflation to be a
problem.
"Though longer-term inflation expectations remain well contained,"
declared the Fed's statement accompanying its rate hike, "pressures
on inflation have picked up in recent months and pricing power is
more evident."
This simple phrase erased billions of dollars of paper wealth in the
span of a couple hours.
It is true, of course, that rising rates are not usually a great
thing for asset prices. But they are not always disastrous. To
generalize, FALLING interests rates tend to encourage speculation in
all manner of financial assets. Conversely, rising rates tend to
reacquaint investors with the concept of risk-aversion. And a risk-
averse investor is usually a seller of speculative of financial
assets like emerging market stocks and bonds, as well as U.S. junk
bonds and small cap stocks. In short, the riskier the asset, the more
damaging the effects of rising rates...at least that's the
conventional wisdom.
If this wisdom proves true during this particular interest rate
cycle, the red-hot emerging market stocks and U.S. small caps
depicted below might be due for a lengthy cooling-off period.
However, commodities and resource stocks are somewhat more difficult
to handicap. That's because they are very schizophrenic creatures in
a rising rate environment. They are speculative, to be sure. But they
are also inflation hedges, which tend to excel during cycles of
rising interest rates.
Therefore, this week's steep selloff in nearly every financial asset -
- including gold -- compels us to ask ourselves two questions: 1) Is
this the beginning of a serious correction in financial asset prices?
2) Once this correction of uncertain duration runs its course, which
financial assets are most likely to reassert themselves?
To preview our conclusion: Financial assets that melt slowly when
exposed to extreme heat are likely to perform better than those that
burst into flames.
As a guide to the future, let's examine a small slice of recent
history: 1994.
The most recent example of a "shocking" rate hike by the Fed occurred
11 years ago, on February 4, 1994. On that fateful day, recalls
Matein Khalid of the Khaleej Times, "Chairman Greenspan dropped a
bombshell on Wall Street. The Fed raised overnight Funds Rate from 3
to 3.25 percent. To the world, this was no big deal, a routine
monetary tightening response to a slight up tick in inflation and GDP
growth. However, on Wall Street, it was pure panic, a Black Death in
the capital markets. Within two months, an estimated $1.5 trillion
was wiped out in the bond markets. ... Orange County, the wealthiest
in the United States, went bankrupt. David Askin, one of world's
leading mortgage derivates managers, blew up his entire $600 million
hedge fund. Dozens of supposedly 'safe' U.S. Treasury and money
market funds lost 10-30 percent of their capital whose beneficiaries
were literally widows and orphans. Proctor and Gamble, which is
supposed to make money selling Pampers, needed Pampers itself as its
structured Libor notes went ballistic."
Ninety days after Greenspan's February 1994 shocker, every major
financial market had fallen, especially the bond market. 10-year bond
yields soared from 5.87 to 7.11 percent. The commodity markets shared
the bond market's pain, as the rising rate trend threatened to slow
the world economy and curtail demand for natural resources.
However, one year after Greenspan's infamous rate hike, the S&P 500
and the CRB Index had both recouped their losses. Crude oil was up 20
percent and copper -- the commodity with a PhD in economics -- had
gained 50 percent. In other words, Greenspan's "shocking" rate hike
of February 1994 jolted the commodity markets but did not electrocute
them.
We expect history to repeat itself. In other words, the commodity
bull market is merely resting, not retiring.
In the "oil glut" days of 1994, the supply of oil swamped demand.
What's more, China consumed less than half the oil per day that it
does now ... and still crude oil jumped 20 percent in the face of
rising interest rates. Oil possesses a much more bullish profile
today than it did in 1994, and so do most other commodities. Whether
rates are falling or rising, supplies struggle to keep pace with
demand.
"China's long-run rise is inevitable," observes Justice Little, co-
editor of Outstanding Investments. "Long-term erosion of the dollar
is equally sure. For both of these reasons, I agree with Jim Rogers'
assertions that we are in the early stages of a commodity bull market
that could last another decade or more."
Even so, Justice admits, "China may have gotten ahead of itself and
the dollar still has the ability to confound in the near term. ... We
have to be prepared for potentially rough waters in the latter half
of 2005. ...China is a compelling long-run story, but in the short
run, the dragon may be close to overheating. Shanghai, for example,
is experiencing a real estate bubble every bit as over-the-top as
southern California's, and the fidgety nature of 'hot money' being
pumped into China's infrastructure development is making even the
most aggressive money managers nervous.
"In addition, the Federal Reserve is finally admitting what everyone
else saw a long time ago: that inflation is taking hold and the
interest rate hikes may need to accelerate. The Fed slamming on the
brakes could temporarily put the brakes on U.S. consumption as well,
and an ensuing slump in demand could temporarily take the wind out of
crude oil's sails."
"This is not an alarm signal as much as a watch signal," Justice
warns. "Crude may yet break through $70 without a hitch. Given that
possibility, however, it's crucial to recognize that we are entering
a delicate stage of the game. Multiple trends that have been intact
for the past year, if not longer, are showing signs of fraying ...
and clear potential for unraveling is at hand."
We acknowledge this potential. But we also acknowledge the potential
for the Federal Reserve to fail in its efforts to quell inflation,
and the potential for global demand trends to drive commodity prices
much higher and the potential for investors to prefer holding gold to
dollars.
In short, we suspect the commodity bull market is more powerful than
Alan Greenspan's lexicon.
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RECOMMENDED INTERNET SITES
FOR DAILY MONITORING OF GOLD
AND PRECIOUS METALS
NEWS AND ANALYSIS
Free sites:
http://www.cbs.marketwatch.com
http://www.capitalupdates.com/
http://www.silver-investor.com
http://www.thebulliondesk.com/
http://www.goldismoney.info/index.html
http://www.minersmanual.com/minernews.html
http://www.a1-guide-to-gold-investments.com/euro-vs-dollar.html
http://www.investmentrarities.com
http://www.kereport.com
(Korelin Business Report -- audio)
http://www.plata.com.mx/plata/home.htm
(In Spanish)
http://www.plata.com.mx/plata/plata/english.htm
(In English)
http://www.resourceinvestor.com
Subscription sites:
http://www.lemetropolecafe.com/
http://www.interventionalanalysis.com
http://www.investmentindicators.com/
Eagle Ranch discussion site:
http://os2eagle.net/checksum.htm
Ted Butler silver commentary archive:
http://www.investmentrarities.com/
----------------------------------------------------
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Dr. Fred I. Goldstein, Senior Broker
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The Moneychanger
Box 178
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Franklin Sanders
1-888-218-9226, 931-766-6066
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