The Incredibly Shrinking Dollar?

The greenback has surged 6 per cent in the last month alone. The
euro, on the other hand, has been caught in the same recessionary
downdraft that is buffeting a number of other currencies, all of which
are unwinding at the same time although unevenly. Currency markets
don't move in straight lines, but don't be fooled, most paper money is
steadily losing value due to the unprecedented expansion of credit.
Investors are moving to cash and hunkering down; the stock and bond
markets are just too risky and real estate is in a shambles. As the
equity bubble continues to lose gas, balance sheets will have to be
mended and lending will slow to a crawl. At present, Germany's
slowdown and Spain's housing crash are drawing most of the attention
but, the spotlight is shifting fast. Next week it could be shining
down on the America's failing banking system or poor corporate-
earnings reports in the US. Then it will be the dollar marching off to
the gallows.

Europe's troubles have put to rest to idea that other countries can
"decouple" from the US and prosper without the help of the US
consumer. That might be true in the long-term, but falling demand is
already visible everywhere. Retail and auto sales are taking a
thumping and 2009 is shaping up to be even tougher. It's looking more
and more like the Europeon Central Bank was faked-out by the early
signs of inflation and missed the deflationary sledgehammer that was
about to come crashing down. It was a catastrophic blunder by European
Central Bank (ECB) chief Jean Claude Trichet and it could cost him his
job. Raising interest rates while sliding into the jaws of recession
is madness. Now all of Europe is headed for a hard landing and there's
no way to soften the blow. The ECB doesn't have the same tools as the
Fed; Trichet can't simply backstop the whole system with green paper
and T-Bills like Bernanke. He can either slash rates or sit on his
hands and hope for the best.

Deficits are expected to soar in the European south (particularly
Spain, Greece and Italy) while growth in the industrial north, e.g.,
Germany, will continue to shrink. Also, Spain, Ireland and England are
undergoing the biggest housing meltdown in history after indulging in
the same mortgage hanky-panky that took place in the US. Billions of
dollars of low interest loans, that were issued to unqualified
mortgage applicants, are gumming up the whole system and sending
foreclosures skyrocketing. Now the losses have to be written down and
thousands of unoccupied houses sold at auction.

The perception that the dollar is getting stronger is mostly an
illusion. Deflation is "dollar positive" because investors who flee
from toxic assets naturally move into cash. But that doesn't mean they
have faith in the dollar; far from it. The fundamentals for the
greenback get worse by the day. Fiscal and trade deficits are out of
control, the national debt is tipping $10 trillion, foreign investment
is drying up, and confidence in US leadership has never been lower.
Paper currency is a country's IOU; and foreign central banks are wary
of taking checks from a country that no longer wins wars or has the
capacity to pay off its debts. That's why, for the first time, there's
serious talk about the US losing its triple A rating on government
debt. And it could happen sooner than anyone thinks. Every time the
Fed uses the dollar to prop up the faltering banking system or provide
limitless capital for defunct GSEs like Fannie Mae and Freddie Mac,
the dollar comes under greater and greater pressure.

As the US housing market continues to collapse, trillions of dollars
in equity and credit are disappearing in a deflationary bonfire. When
a $400,000 home--with no down payment and negative equity--goes into
foreclosure; $400,000 vanishes from the digital-pool of credit and has
to be written down as a loss. So far, much of the losses have not yet
been accounted for because the banks are using their own internal
models for determining the value of their downgraded assets. Two weeks
ago, Merrill Lynch sold $30 billion of mortgage-backed junk for 20
cents on the dollar. But they also financed the deal, which means that
they really only got 5 cents on the dollar! This reflects the true
"market value" of these assets. They are virtually worthless.
Naturally, Merrill's sale sent tremors through Wall Street where banks
and other financial institutions are sitting on trillions of dollars
of this garbage marking it down at a few percentage points every
reporting period rather than doing what Merrill did and putting it all
behind them. As a result, the banks have less capital to lend, which
means economic activity will continue to slow and the country will go
into a deep recession. The point is, that the Federal Reserve now
holds about $400 billion of this junk-paper on their balance sheets
and the US Treasury is planning to take on hundreds of billions more
(perhaps as mush as $800 billion more under the new legislation!) to
prop up Fannie Mae and Freddie Mac. The Bush administration is using
the credibility of the dollar as collateral in its plan to bail out
the most reckless, high-stakes Wall Street gamblers.

So, how does this affect the dollar?

The nation's debts are entirely balanced atop its currency. The
greenback is like a circus strongman holding a barbell precariously
over his head; as the weight is increased, the sweat begins to appear
on his brow while the veins in his neck and forehead begin to bulge.
Finally, the knees buckle and the and the over-matched weightlifter
crashes to the canvas in a heap. That's the future of the dollar in a
nutshell.

But how does that explain the sudden fall in gold prices; after all,
gold is the logical alternative to paper money, right?

Wrong. Gold is "real money" alright, but it's also a commodity. And
when commodities are smashed by a deflationary tidal wave--as they
have been the last few weeks-- gold will follow them into the
basement. In truth, gold has taken an even worse pasting than the
euro; free-falling from $980 per ounce in mid-July to $786 at Friday's
market close. $194 in a month.

When the economy is in the grips of deflation; all asset-classes get
dragged down, gold included. Many of the hedge funds and other big
market players are selling their gold positions recognizing that the
commodities boom is over and it's time to move on. That doesn't mean
that gold won't rebound sharply when Bernanke slashes rates or if Bush
blows up some new part of the globe. It simply means that in the short
term, "cash is king". Pension funds and hedge funds will continue to
deleverage to reduce their credit exposure to put themselves in a
better position to roll over their debt. That means that gold's slide
could last a while. This doesn't look like a conspiracy to me, but I
have my tin-foil hat in hand just in case.

No one knows where the bottom is for gold, but one thing is certain;
its future prospects are a lot brighter than the dollar's. The Bush
administration has yet to demonstrate that it can enforce Dollar
Hegemony via military intervention. That is a very big deal indeed. If
the dollar isn't backed by Middle East oil, then the $6 trillion
stockpile of dollars and dollar-denominated assets that are
languishing in foreign central banks and sovereign wealth funds, will
continue to dwindle until the dollar's position as "reserve currency"
comes to an end.

That's one doomsday scenario, but there is another one, too. If
Bernanke and Paulson continue to pile all of the nation's credit
problems (bad paper) on top of the greenback; foreign capital will
head for the exits and the dollar will crash. Either way, the dollar's
troubles are mounting and something's got to give.