Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Little Dutch Boy Lessons for the Fed:  Brazil, Japan, and others are wishing that someone would poke their finger in the money dam.  A mounting flood of dollars is now hitting the markets worldwide.  In our previous comments of May 7th, we warned of a developing “beggar thy neighbor” issue that now seems to be kicking into high gear.  As the Fed prints new dollars (at an annual run rate of almost a half a trillion over the last several weeks), either to save the economy or to give the Democrats a break in November, those dollars are finding their way to other currencies (and gold) in a big hurry. It’s forcing foreign governments to intervene and buy those dollars to stem the decline in their exports to the U.S.

Here’s the catch, when those foreign governments print their currency to intervene, they don’t have a buyer for the excess.  The net result is a lack of support for their bonds and a corresponding rise in rates – essentially choking their internal sources of financing.

On the Fed’s latest monetization spree, which saw an average of nearly $10 Billion freshly printed dollars a week, Brazil’s rates popped 32 basis points, translating into a nearly 3% loss since the end of August.

Japan is experiencing a similar dilemma, as the yen has appreciated nearly 11% against the dollar since May. Large institutional investors that own some 62% of Japan’s government debt are beginning to look for the exits as the JCB steps up its printing to stem the gains.  We could soon see a rise in rates in Japan, which would be a first in the last 15 years or more.

We have stated this before: Foreign governments do not have a printing press like the U.S. does.  They do not have as many buyers as the U.S. does for artificially created units of currency.  When they try to copy the U.S., inflation ensues and cripples their economies even more.

What has not been discussed in the headlines, but will be the future issue, is this: If foreign governments realize they can’t afford to buy our excessively printed currency, what eventually happens to U.S. government bonds and equities?  It’s been a slow motion crack-up so far, but if we keep moving this direction, we can reasonably say that it won’t be pretty when the damn breaks.

Chart of the dollar:

Dollar Chart, 10-1-10

2. A Note from David McAlvany: I’ll be in New York in a matter of weeks, exchanging ideas with a small group of investment professionals at the Plaza Hotel.  The Plaza, as you’ll recall, was the gathering spot for a few select bankers twenty-five years ago this week (September 22, 1985).  They developed the Plaza Accord – a coordinated monetary intervention that devalued the dollar by over 50% relative to the Yen and German Mark.  It was a pivotal time in the international currency markets.

There are echoes of history in recent weeks, and the irony of timing is most entertaining to us.  This devaluation of the ’80s was a thoughtfully executed and jointly sponsored scheme orchestrated by a half dozen central bankers from around the globe.  Perhaps it is now the Yen’s turn for a globally concerted devaluation.  But wait, everyone wants that turn, and everyone wants that turn now.  This time around, it may not be so well coordinated as countries push and shove to lead the whole fiat pack lower.

Currencies, it seems, are more important than ever.  As a result of the wealth generated by world trade and global cooperation, developing countries have grown their share of the money pie (China’s economy, in years past only twice the size of Belgium, now has the second largest economy in the world).  They are naturally reluctant to give any of it back.

Now, exports feature more prominently than ever as a key component in global and individual country GDP.  But here’s the rub.  There is a fight emerging over a diminishing share of income and wealth still generated from exports, as the global economy continues to sputter.  Politicians (along with their monetary henchman) are not inclined to cooperate as they have in times past.  They are thinking and acting locally. The likelihood of a currency war is in fact growing.  In the article David Burgess mentions above, Brazil’s Finance Minister, Guido Mantega, stated this week that “we are in the midst of an international currency war. This threatens us because it takes away our competitiveness.”

With this in mind, here is a brief recap: The dollar broke down in the worst quarter since 2002 – sinking below .79.  The Japanese Yen moved to heights we haven’t seen since 1995, prior to the Asian contagion and associated all-time highs relative to the dollar.  Gold set new highs – again. Silver broke out to 30-year highs.  Copper and Oil continue to climb (though deflation is still the stated concern of the fed).  And the global equity markets moved higher in concert, though remaining far from their recent peaks.

What this continues to communicate is that all assets are correlated to the flow of liquidity coming from the world’s central banks.  When it comes to currency intervention, the consistent theme – lacking any conspiratorial subplot – is one of national self-interest.  The creation of liquidity serves two purposes: to buoy asset values, and to lower the value of domestic currencies in order to recapture the dream of limitless GDP growth and newfound streams of income to an emergent middle class.

The challenge for central bankers (Ben B. and the Boys) is to maintain control of these devaluations, and while buoying asset prices (if they can continue to do so) also buoy the spirits of the general public in order to avoid a money panic.  Such a panic is not easy to predict, as it is purely psychological and social in nature.  The evidence for the erosion of system-wide confidence is clearer to see, as individuals the world over transition assets to gold in anticipation this eventuality.

Have a wonderful weekend.

David Burgess
VP Investment Management

David McAlvany
President and CEO