Editor’s note:

The stock market took a beating on June 5, 2006, as Federal Reserve Chairman Ben Bernanke made it clear that the central bank was not likely to pause in June on its quest toward higher interest rates.

The markets were surprised, and again showed that traders have a short memory as the original shot was fired over a week earlier when Fed Governor Janet Yellen first told an audience that the Federal Reserve was willing to raise interest rates in order to keep the U.S. dollar strong.

In this analysis Dr. Duarte looks at the potential ramifications of a Federal Reserve that is ignoring a weak economy, but has little choice than to defend the dollar.

Dr. Duarte noted this key development and produced this analysis on May 30, 2006 at www.joe-duarte.com.

Fed Governor Yellen Ready To Defend Dollar
First Sign Of Currency Fear Appears

San Francisco Federal Reserve Governor, and voting member of the Federal Open Market Committee (FOMC), Janet Yellen told reporters over the weekend that a weak dollar "would appear to call for a response of tighter policy."

The statement published in a weekend article by Reuters was largely ignored by the mainstream media, but if joined by other Fed voices could signal a major turning point in monetary policy, that of using interest rates, not just to quell inflation, but also to defend a weak currency.

If indeed that is what Ms. Yellen meant, it could signal a major turning point for global currency markets, and could become a spark for volatility as well as currency flight.

Hawkish Talk From A Dove

So, why are we so interested in an obscure story about Janet Yellen, one of the less flamboyant, and often dovish Fed Governors? Because she is not usually on the hawkish side of the interest rate issue, which in and of itself suggests that there is a major sense of concern on the part of the Federal Reserve.

In 1995, when Mr. Greenspan wanted to raise rates one more time, as an insurance policy against inflation, Yellen and then vice-Chairman Alan Blinder, dissented with Greenspan, who got his wish anyway.

One Bloomberg columnist, John M. Berry, on May 23rd, noted: ["Eleven years ago Yellen was a member of the Fed Board, and at that February meeting she joined then Fed Vice Chairman Alan Blinder in trying to persuade Greenspan to wait for more data. "I do not think we should feel compelled to raise the funds rate today, and I do see definite benefits from waiting a little longer to decide," Yellen said, according to a transcript of that meeting. "I fear that if we act today, our move may turn out to be one we will regret."]

Yet, as Berry points out, 1995 and 2006 are similar, especially in the fact that the Fed has been on the rising end of the interest rate curve for some time, and there are some signs of weakness that are starting to appear.

In fact, as Berry points out, "In her last public speech on April 18 -- several weeks before the committee raised its target for the overnight lending rate to 5 percent on May 10 -- Yellen said she expects economic growth to slow later this year."

So what's different? Nothing really. In fact, it sounds to us as if Ms. Yellen is looking at two sides of the same issue. One, commodity prices remain high, despite recent pullbacks. And two, despite significantly higher interest rates, the dollar is barely forming a base, and not showing much sign of starting any kind of new bull market, although that may change at any time.

A New Conundrum

Alan Greenspan talked about a "conundrum," in his last year at the helm of the Fed. He was referring to the fact that although commodity prices continued to rise, long term bond yields remained low.

That scenario has shifted moderately over the last few weeks, but is still mostly intact, as gold, oil, and industrial commodity prices have rocketed, but the U.S. Ten Year note yield, has barely crossed the 5% barrier, and may soon fall below that key benchmark, if the economy shows sign of slowing.

So what's left? How about a new conundrum? Instead of buying U.S. bonds, the hoard of international savings, has been putting its money in what it understands, gold and tangible assets.

Sure, in China, Brazil, and India, bull markets in stocks have been flying high. But, at the same time, we've even had major rallies in the thinly traded platinum market and silver, usually a lagging commodity.

What no one is saying, is that while the U.S., and to a great degree, Europe remain relatively safe and comfortable places, Africa, Asia, the Middle East, and South America, are in turmoil, politically, and in some cases military.

There are rebellions, counter rebellions, wars between cartels, assassinations, and massacres in many areas of the world on a daily basis.

So we have two major dynamics at work.

Governments and banks, which are presumably more sophisticated investors have continued their purchases of paper assets.

But, for anyone else who has any money, and who has not been able to escape any of these calamities, there is only one thing to do, put their money in something that has stood the test of time, something tangible, such as gold, silver, or platinum.

What's the bottom line? Until Asia gets a big time corporate market, the huge savings glut of the Asian masses, will continue to buy what it knows, commodities.

Bloomberg's Andy Mukherjee puts it succinctly when he notes: [ "Blame it on Asia's household savings rate of about 40 percent of total assets, double the U.S. and European levels. A high savings rate and abundant liquidity ``tend to militate against the development of a bond market,'' Zhou Xiaochuan, governor of the People's Bank of China, noted in a recent BIS study. ``Corporations with good credit standing do not have strong motivation to issue bonds as they can easily obtain loans from commercial banks at low interest rates. If bond buyers are mainly institutional investors and financial institutions with too much liquidity on hand, they may not be very interested in trading in the secondary market.'']

Add the potential for a resumption of capital flight from the U.S., as international investors repatriate cash by selling U.S. bonds, and you have a third rather negative factor to deal with.

According to Jephraim P. Gundzik, at www.pinr.com: "As U.S. bond yields have risen, the value of the dollar against both the yen and the euro has declined, signaling that foreign capital flight from the U.S. may have already begun. The dollar has depreciated by about eight percent against the euro and about five percent against the yen between January 1 and May 22, 2006. The sale of dollar-denominated bonds by foreigners is shifting the global dollar bubble back into the U.S. money supply. This added liquidity undoubtedly helped to propel U.S. economic growth higher in the first quarter of 2006. It has also added to already growing inflationary pressures in the United States."

Conclusion

Some inside the Fed are starting to get impatient with the progress being made on the commodity price front.

After fourteen rate increases, gold is still trading above $650, while the dollar is hovering near its five year lows.

In other words, the Fed's work has barely kept inflation from getting completely out of control, and has done little to add strength to the U.S. currency.

Ms. Yellen, rather than being confused, is just stating the facts. Clearly, the Fed is worried, as it has yet to make significant progress in its goals against inflation.

What Ms. Yellen is not saying is that this time, the game is a bit different. The Fed is having to do a more difficult job than usual, which is to mop up global liquidity, not just the excess dollars from the United States.

What Ms. Yellen is not saying is that the post 9/11 dollars that left the U.S. in a hurry when the Fed eased massively after the Twin Tower attacks made their way to Asia, and other places.

There, they were converted to Yuan, and Rupee, and Yen. And from there, they have been slowly making their way to the gold, silver, and platinum markets.

In our opinion, Ms. Yellen, and the Fed are slowly coming to grips with the gravity of the situation. Her remarks show that Ms. Yellen may just be starting to come to grips with the fact that despite the potential for an economic slow down, perhaps of some significance, the Fed may have to continue to raise interest rates indefinitely, just to keep the dollar from collapsing.

Ms. Yellen, dove or not, has been around the Fed along time. In our opinion, her recent remarks are a clear attempt by an old hand to sound out the market's possible responses to a very unpleasant set of circumstances that the Federal Reserve may have to unleash on the global economy, and the financial markets.

If and when the market finally gets what Ms. Yellen is trying to say, life could get a whole lot more interesting.

© 2006 Joe Duarte, M.D.
Dr. Duarte's Bio and Archive