Waging War Against the Forces of Deflation and Depression

As the dollar careened toward a 15-month low yesterday, gold zoomed to a new all-time high. Once the dust finally settled, the Dollar Index closed the New York trading session at 74.41 – its lowest closing price since August 7, 2008, the day AIG (AIG) reported the third of its shockingly large quarterly losses.

Back in those days, the world at large was just beginning to learn the full extent of the rot that permeated the US financial system…and about the rodents who nourished themselves off the rot. But the Treasury and the Fed were already meeting in their war rooms, drawing up plans and arranging strategic alliances with various scoundrels.

Bear Stearns, Fannie Mae (FNM) and Freddie Mac (FRE) had already gone bust. AIG and Lehman Bros. (LEHMQ) were on their way. But even before these shocking stories first crossed the newswires, the US Treasury and Federal Reserve began waging an all-out war against the forces of deflation and Depression.

Their “secret weapon?” Dollar depreciation.

Flood the financial system with liquidity, the heads of the Federal Reserve and the US Treasury reasoned, and the burdens of extreme indebtedness will become less burdensome. Banks can recapitalize their balance sheets and the financial sector can recover.

This reasoning seems reasonable…until you understand that “liquidity” is just shorthand for “printing dollars.” If the Federal Reserve did not conjure dollar bills into existence from thin air, it could not create any additional liquidity for the system. It’s as simple as that. But of course, the processes that actually funnel liquidity into the financial system are not simple at all. They are cloaked in the sober language of economist jargon and conducted under the veil of opaque and complex transactions between innumerable “lending facilities” and counter-parties. To do anything less would be irresponsible.

But the net effect of these complex processes is no different than turning on a printing press, leaving a monkey in charge of replacing the toner cartridges and going on vacation to Tahiti for a month. By the time you had returned – tanned and rested – you’d find hundreds of billions of new dollar bills all over the place, dozens of empty toner cartridges and one pissed off monkey.

This situation, more or less, resembles the current condition of the US monetary system. The US money supply has exploded and the global monetary system is a messed. You won’t find any pissed off monkeys, but you’ll find plenty of pissed off dollar-holders. These folks are not happy that US monetary authorities are intentionally sacrificing the dollar’s purchasing power in order to rescue the economy.

Thus, to return to our military metaphor, the dollar’s value is taking more direct hits than an Al Qaeda hideout. Nevertheless, Generals Bernanke and Geithner are claiming victory against deflation and Depression. And maybe that’s true…as long as you ignore the rockets’ red glare and the bombs bursting in air over the foreign exchange markets.

But the gold market is not ignoring these monetary pyrotechnics, which is why the gold price advanced to a new all-time high yesterday of $1,200 an ounce.

The stock market is not oblivious to the dollar’s weakness either…nor to the inflationary implications of the greenback’s withering purchasing power. In fact, the stock market is behaving very much like a pure inflation hedge. Every day that the dollar loses big, the stock market gains big…and vice versa.

In other words, the struggling American economy does not seem to validate the soaring stock market. But the dollar’s weakness does…at least partly. Unfortunately, a bull market in stocks that relies more upon dollar-hedging than underlying economic strength is a bull market that should leap out of bed every morning, grateful for one more day.

The stock market might continue leaping out of bed for many days, or weeks, to come. But the risks are increasing that this seemingly healthy stock market won’t be able to fog a mirror. In fact, some of the “market internals” are already showing signs of deteriorating health.

As the top half of the nearby chart shows, small cap stocks and finance company stocks led the rest of the stock market out of the depths of the March lows. But as the bottom half of this chart shows, the same sectors that led the stock market off the bottom are now leading in the opposite direction. During the last seven weeks, while the Dow has advanced 5%, the Value Line Index has slumped nearly 5% and Goldman Sachs has tumbled 13%. These striking divergences do not necessarily bode ill for the entire stock market, but like a low white blood cell count, they do not bode well.

[The nearby chart would illustrate the intended point even more clearly if our graphics art department had not made one slight error. The top half shows the performance of Goldman Sachs, the Value Line Index and the Dow Jones Industrial Average between March 9 and October 14. The bottom half shows these same securities and indices from October 14 to the present.]

By Eric Fry

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