The markets have calmed significantly ever since Bernanke “opened the discount window” and cut the four-week Fed interbank rate from 6.25% to 5.75%. The volatility index (VIX), for example, is down from a five-year high of 37 to a comparatively placid (but still well above average) 24.

The Fed did not “bail out” financial institutions per se. Bernanke used a little-known (and vanishingly insignificant) tool which the market did not understand, and combined that with dropping inflation-hawkish language in Fed statements, to suggest that the Fed was prioritizing economic stability over a rapidly rising inflationary threat. The market wasn't exactly sure what the impact of the four-week rate cut would be, but it figured that the Fed's dropping of its own inflation language meant something good, so it rallied anyway. In other words, Bernanke calmed the markets without doing anything substantive. It restored some measure of Street cred to the man whom traders (still) deride as “Helicopter Ben” (Bernanke once joked – on the record – that the Fed could drop money from helicopters as a monetary tool), and who accidentally freaked out the markets early in his tenure with an ill-advised interest-rate comment to CNBC's ubiquitous money honey, Maria Bartiromo, at a VIP dinner.

So What Does That Mean?

However, according to Fed rate-cut options, the market is now certain of a 25-basis point cut in the Fed's benchmark interest rate, and assigns a 60% probability of a 50-bp cut in the benchmark interest rate. Bernanke indicated today that, now that the credit markets have calmed down quite a bit, the Fed will return to minding inflation. The market is still effectively assuming a “financial put,” i.e., the Fed will cut rates by whatever necessary to save the major financial pillars of the United States (huge hedge funds and investment banks) from going bankrupt. Bernanke is extremely conscious of the fact that the last (brilliant) financial academic too chair the Federal Reserve, Arthur Burns, was manipulated by others to unleash extreme inflation for minimal short-term gain. Burns went down as one of the worst Fed chairmen in history, and Bernanke's latest remarks demonstrate that he has no interest in going down the same road of yielding to desperate Wall Street banks choking on their own recklessness.

While it is fortunate for the long-term future of the dollar that Chairman Bernanke has more spine than he was given credit for, Bernanke is still very boxed in. The economy is not doing well, and a wave of foreclosures will throw several million people out of their homes. Political unrest from high-growth swing states and their representatives (Nevada and Florida, for example,  have some of the highest foreclosure rates in the nation) will cause Congress to demand too much easing on the part of the Fed. At the same time, the Fed does not have much room with which to ease.

The Fed's “inflation ex-food ex-energy,” “core” inflation targeting has encountered a crescendo of criticism (leading some to refer to it sarcastically as “inflation ex-inflation”). The Fed has made a practice of largely excluding food and inflation prices from its calculations, because they have been extremely volatile in the past. However, that volatility has been all upward in the past several years, and inflation including food and energy has been running well over 3 percent for many months.

Additionally, the “China deflator” effect is vanishing. Longtime readers know this has been a particular hobbyhorse of mine, and that the grotesquely distorted Chinese capital market allows well-connected Chinese companies to effectively sell products below cost. Thus, prices on many manufactured goods plummeted, which led to an era of lower inflation in Western countries which imported from China.

An August 19 article by MIT's Lester Thurow (featured in the NYT) somewhat vindicated my suspicions. Thurow, like yours truly, has always been contemptuous of official Chinese growth statistics. Using his own measurements, mainly electricity consumption, Thurow concluded that China's actual annual GDP growth rate before adjusting for inflation is optimistically between 4.5 and 6 percent – less than half the official figure. Half of China's GDP growth since 2000, in other words, has been a combination of under-the-radar inflation and pure BS.

As Bernanke and his fellow monetary high priests try to divine actual future inflation, the erosion of the China deflator effect will loom ever larger on the horizon even as shorter-term inflation argues all the louder against an interest-rate cut.

At the same time, the dollar has been falling for geopolitical as well as economic reasons. A lot of increased demand for euros and supply of dollars in the global forex market has stemmed from two groups of governments discontented with American monetary hegemony: Asian exporters who have vast trade surpluses with the United States, and oil exporters increasingly at odds with the US government in Iraq and the former USSR.

Russia, China, and the petro-sheikhs of the Middle East are collectively sick of having their economic well-being anchored to the Federal Reserve, which can theoretically act as a powerful arm of US foreign policy in conjunction with the Treasury Department (very problematic for them, because they are also all invested in American defeat in the Middle East to some extent – even China). All are eager to be unshackled from the value of the dollar. As they continue diversifying away from the dollar, the dollar has nowhere to go but down unless the US trade balance dramatically self-corrects.

1998 vs 2007: Why It's Different This Time

In Greenspan's handling of the Long Term Capital Management fiasco of 1998, the strength of the dollar at that time gave Greenspan much more room for monetary maneuvering. Furthermore, there were no structural factors portending a longer-term decline of the dollar in 1998, as there are now (central banks slowly selling dollars to diversify, for political as much as economic reasons).

Another difference, as Nouriel Roubini and others smarter than I have already pointed out, was that while LTCM was a liquidity crisis, the current mess is not only a liquidity crisis but a solvency crisis as well – and one that is spread across dozens of major financial institutions. LTCM was a centralized catastrophe, so while the problem was existential in scope, the scope became very clear very quickly. The extent of the subprime debacle, on the other hand, is not clear at all. It might be existential, or it might not. It might cause Lehman or Bear Stearns to file for Chapter 11, or it might not. Nobody really knows, and although the markets have calmed down for now, another big mortgage-lender bankruptcy could easily put the market on hair-trigger, 33-VIX territory again. If the markets' expectations for lowered interest rates at that point in time have been disappointed, the Dow will make a beeline for 11,500.

There are two ways this can go.

One, the market will be disappointed to learn that Bernanke will not in fact lower interest rates. Bonds and the dollar will win. Equities and especially commodities will tank. Near-term pain for long-term gain.

Two, Bernanke will relent, and Wall Street will get another bailout. The dollar will fall even faster, the economy will appear somewhat robust, and necessary readjustment pains will be pushed down the road for about two more years.

Bottom Line

Bernanke's actions are more important than ever. I see Bernanke as more of an inflation hawk than the market does, which gives my outlook on the bearish overall situation even more bearish overtones. However, trying to forecast what the Fed does is a notoriously impossible enterprise; all I can do is attempt to ascertain what the Fed's best interest is – which I believe lies in some measure of inflation/ dollar hawkishness, even in the face of rising domestic political clamor – and assume that they will do what is in their best interest as a credible global institution.

The subprime crisis is still alive and well, and the critical mass of foreclosures (the pressure point for the mortgage lenders) hasn't even hit yet (they are due for 2008 and 2009). I see equities as either going sideways or down. It will take exceptionally good news to clear the pallor of pessimistic uncertainty hanging over the markets right now. Considering how unlikely that is, relative to the pretty sure diet of bad news coming over the next two years, I would stay away from dollar-denominated assets other than T-bills for some time yet.

I have been an oil bear for quite some time. Nymex spot is now under $69.50, from my call of $74 three weeks ago. I expect it to keep falling, although it will be extremely volatile and contingent upon what the Fed does. If the Fed lowers interest rates (effectively passing out Grey Goose to make the i-banks' hangover go away), the party will go on for some time, and oil will be back in mid-70's territory. The dollar will walk off a cliff, and gold will breeze above $700.

If Bernanke applies the rougher medicine, as I think he will, oil and metals will keep falling, because short-term economic activity will bleed the losses out of its system, as it must do at one point or another. Under this more-probable-but-still-very-uncertain scenario, the dollar will gain significantly. Even if US equities will suffer, the dollar's rise would largely compensate for that against global equities.

However, there is still too much uncertainty to justify the transaction costs required to make a big move. I am still at “wait and see,” but leaning towards cash and gold.

Cheers,

Alex Forshaw

Editor in Chief

http://www.bestwaytoinvest.com