The Fed did leave itself some room for maneuver for hiking rates further, but the growing consensus is the Fed is going on vacation this summer. Foreign currency traders who bought the US dollar since June 5th, expected to hear a story about the epic battle against the global inflation. Instead, what currency traders heard on June 29th, was a two-handed Princeton economist, whose tough rhetoric about fighting inflation, had come down several notches from just 24-days earlier.

One the one hand, "moderation in aggregate demand should limit inflation pressures over time. Ongoing productivity gains have held down the rise in unit labor costs, and inflation expectations remain contained." However, on the other hand, "the high levels of resource utilization and prices of energy and other commodities have the potential to sustain inflation pressures," the Fed said.

Since his nomination to lead the Fed, "Helicopter" Ben Bernanke's reputation as a super-dove on monetary policy, has been impacting the global money markets. Gold is 33% higher to roughly $620 per ounce, and the US Treasury's 10-year note yield has climbed 70 basis points to 5.15%, a four year high. On May 1st, Bernanke confided to CNBC's Maria Bartiromo, that "it's worrisome that people would look at me as dovish and not necessarily an aggressive inflation-fighter".

To shed his dovish feathers and appear more like a wise old owl, Bernanke authorized three quarter-point rate hikes to 5.25% under his watch. But dusting off his dovish reputation won't be so easy, as evidenced by the plunge in the US dollar, and surging commodity and gold prices. Faced with a stark choice of defending the US dollar or defending US home prices, Bernanke dropped the greenback.

The dollar tumbled 2-yen lower to 114.50-yen, and the Euro rallied 2.5 cents to $1.28, after the Fed signaled it was near the end of its rope of raising rates. Metals, energy, grains and soft commodities rallied strongly, laughing at the Fed's observation that "inflation expectations remain contained". Copper surged almost 4% in London and gold sprinted $40 per ounce higher to $623 /oz, to regain its old footing above $600 an ounce. Silver surged almost $1 per ounce to $11.27 /oz.

The Bernanke Fed is sub-contracting the job of fighting inflation to the other two big-central banks, the Bank of Japan and the European Central Bank. Other mid-tier central banks around the globe are also on course to raise rates this year, and the Bank of China, and Bank of India, the largest emerging economies with explosive money supply growth, are vowing to drain liquidity in their local markets.

The Bank of Japan is laying the ground work for a quarter-point rate hike to 0.25%, the first hike in six years with the Japanese economy posting 57 months of solid growth, and core consumer prices rising for seven straight months through May. Japan's jobless rate fell to 4.0% in May, an eight-year low, and the number of salaried Japanese employees rose above 55 million for the first time ever last month.

The Bank of Korea's shocked the markets on June 8th, and raised its overnight call rate target by a quarter-point to 4.25%, the fourth rise since October. Bank of Korea Governor Lee Seong-tae indicated on June 12th, that the central bank will tighten its monetary policy again to absorb liquidity in the market. "We are going to run our monetary policy in a way to preemptively react to inflationary pressure," he said.

The European Central Bank has raised its repo rate 25 basis points during the last month of each quarter since December 2005, to 2.75%, and is signaling a tighter policy this year. "All the recent data indicate that risks to price stability are on the upside and have increased," said Greece's central banker Nicholas Garganas on June 27th. "I would not rule out a higher adjustment to rates than 25 basis points, nor a faster pace of rate increases than once per quarter," Garangas added.

The ECB is lingering far behind the monetary inflation curve, with its Euro M3 money supply expanding at an 8.9% rate and European bank loans are 11.4% higher from a year ago, double what the ECB considers to be consistent with low inflation. The ECB could decide to move faster in lifting its repo rate this summer, while the Bernanke Fed goes on vacation, and watching the US Dollar get zapped.

The Swiss National Bank raised its official interest rates by 25 basis points on June 15th, aiming for 1.5%, the mid-point of a 1.0% to 2.0%, 3-month Libor target band. The SNB usually coordinates its monetary policy with the ECB, in order to maintain a stable Euro /Swiss franc exchange rate. The SNB is expected to continue lifting its Libor rate target by 25 basis points in September and December to 2.00%, and could lift the Swiss franc against the dollar as the US rate rise cycle ends.

Compounding the dollar's woes, the massive US trade deficit is sending a huge outflow of dollars to other countries. Last year, the US trade deficit in goods and services hit a record $726 billion, as US imports far exceeded exports. Financing the current US trade deficit requires money from foreign central banks, which already own large amounts of dollars. Recently however, the central banks of Sweden, Finland, Russia, and the UAE have said they will reduce their US dollar exposure.

Behind the shift may be concern that the dollar will be devalued, making their US bond holdings worth less. Higher Treasury note yields are starting to reflect this risk. The Fed has restored the fed funds rate to 5.25%, a five year high, but the US dollar index remains 24% below it levels of 2001. The US Treasury is forced to offer higher interest rates to foreigners, to attract capital to the US markets, and prevent the US dollar from falling under its own weight.

The Fed's June 29th zig zag on interest rates is fraught with many risks, such as inviting a speculative attack against the US dollar and higher import inflation, or foreign central bank switching into other currencies and gold. Beijing has been gradually diversifying its $925 billion of foreign exchange reserves out of the dollar, and Japan was a net seller of US Treasuries by $50 billion since April 2004.

Foreign currency trading is often likened to a reverse beauty contest, where the best currency to own is the least ugly. But the alternative to inflated paper currency is glittering gold, whose supply cannot be manufactured by abusive central bankers. But gold is widely owned by investors around the globe, and big supplies can hit the market at a moment's notice, such as witnessed from 5/11 until June 13th.

Yu Yongding, the chief economist at the Chinese central bank said on June 1st, that Beijing should use its $925 billion of foreign-currency reserves, the world's largest, to buy gold and crude oil as a hedge to guard against the risk of a sudden drop in the US dollar. Beijing has only 1% of its reserves in gold, with more than two-thirds of its reserves invested in depreciating US Treasuries.

The Bernanke Fed is either out of sync with market psychology, or prefers to be reactive, rather than pre-emptive in confronting inflation. But the sophisticated bond and gold vigilantes are not going to be duped by the Fed's brainwashing about "contained inflation expectations," and instead are closely tracking the direction of the global stock markets, for clues about economic growth rates and inflation pressures in the world economy.

In Chicago, despite widespread expectations the Fed will take a vacation this summer, fed funds futures traders are confidently predicting the US central bank will eventually hike its overnight loan rate to 5.50% by year's end. But timing is everything, and a Fed rate pause in August, might allow the inflation genie to escape from its bottle, and then lead to another Fed zig-zag on interest rates in autumn.

July 5, 2006

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