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April Fools Day for Gold

How governments greased the Gold Market's slide on April Fool's Day 2008...

IT WAS "April Fools" Day 2008
, and Wall Street was busy spinning bad financial news into bouts of irrational exuberance, writes Gary Dorsch of

   News of a $19 billion write-down of toxic sub-prime mortgage debt at Swiss bank UBS – plus a $4 billion hit at Deutsche Bank – might have been expected to spark a panic sell-off in global stock markets a few weeks ago.

   But on 1st April, the Dow Jones Industrials soared 391 points instead, while the broader S&P 500 Index jumped 3.6%, posting its best start to the second quarter since 1938.

   Shares in UBS soared 18% after the Swiss bank said it would plug the craters in its balance sheet with a $15 billion rights offering, led by a syndicate of J.P.Morgan, Morgan Stanley, BNP Paribas and Goldman Sachs. Shares in Lehman Bros jumped 22% after it raised $4 billion from the sale of convertible preferred shares, squeezing bearish speculators in LEH puts in the process.

   Before the April Fools day festivities, the S&P 500 Index had posted five straight months of losses, and a 10% slide in the first quarter. In its infinite wisdom, the stock market has already discounted a recession, which probably arrived in the first quarter.

   Earnings for S&P 500 companies are expected -8.1% lower in Q1 from a year ago, down from rosy projections of +4.7% at the beginning of the year.

   But the badly battered US financial sector soared 15% on April Fools day, after British prime minister Gordon Brown called on the Group of Seven (G7) central bankers to stop worrying about "moral hazard" and start backing a joint plan to recapitalize global banks and buy-out the toxic sub-prime mortgages.

   In short, Brown demanded the G7 rescue the banking system. Of course, such a bailout initiative would be funded with taxpayer's money, with a small price of tougher regulation of the industry. But "we have got to make these changes immediately," Brown said on April 1st.

   The man who famously sold Half Britain's Gold Reserves back in 1999, Brownalso discussed his solutions for the global banking crisis with US President Bush at a NATO summit on April 3rd. "We were talking about major issues that we can collectively do about the world economy," he told reporters.

   Brown is also talking with the leaders of Germany and France "about how we can make changes that we need in the world economy, as quickly as possible."

Fed Policy Now Moving the Japanese Yen

   The direction of US Treasury yields and the S&P financial sector is having a big influence over the direction of the US Dollar these days.

   The Dollar/Yen exchange rate is tracking the interest rate differential between the US Treasury's two-year note and the comparable Japanese two-year note. So far this year, the Dollar's interest rate advantage has shrunk to +132 basis points from +250 bp, which in turn has knocked the Dollar from ¥114 to around ¥102.50.

   The Dollar briefly fell to ¥96 – its lowest level in 13-years – when the interest rate spread plunged to as low as 75 basis points. Despite the Dollar's sharp slide under ¥100 and the resulting havoc in the Nikkei 225 stock index, the Bank of Japan was under no pressure from Tokyo to ease its monetary policy.

   Kaoru Yosano, a heavyweight in the ruling Liberal Democratic Party, said that "with short-term interest rates being 0.5%, there is no room to cut rates, and therefore it does not make much sense to do so," taking the political heat off the BoJ.

   Thus the Dollar/Yen's gyrations have mostly focused on the direction of volatile US Treasury yields. And amid sentiment that the Fed's latest rate cutting campaign has almost run its course, the Dollar rebounded above ¥100 this week.

ECB Lets the Euro Combat Inflation, Not Interest Rates

   Compared to the political lackeys at the Bernanke Fed, the European central bankers are super-hawks, refusing to knuckle under to pressure from union bosses and politicians for rate cuts.

   "There is no room for complacency and no reason to believe that inflation has been brought under control. The ECB remains firmly focused on price stability," warned the Bundesbank's Juergen Stark on March 28th.

   "Not only are current price pressures alarmingly high but, faced with moderate though basically robust Eurozone economic growth, and the continued strong money supply expansion, there are medium-term upside risks to price stability," said Bundesbank chief Axel Weber.

   "In this volatile market environment, it is essential to continue to anchor inflation expectations at a low level."

   But for the past several months, ECB official have refused to lift the bank's repo rate above 4%, where it's been stuck for the past 10 months, arguing that a central bank can't produce an extra barrel of crude oil, nor an extra bushel of soybeans, with a tighter monetary policy.

   The ECB has vowed to tighten monetary policy only if "second round" inflation effects, namely wage increases, exceed the general inflation rate.

   Yet last week, German public sector workers won their biggest pay rise in 16-years, equating to a 5.1% rise for 2008, the biggest pay increase since 1992.

   Germany's biggest industrial union also delivered a 5.2% pay rise for steel workers, their biggest in 16 years. Boxed into a corner with their own empty rhetoric, ECB officials are balking at lifting the repo rate to contain the surging Euro M3 money supply.

   Instead, much like the Bank of Japan and the Swiss National Bank, the ECB is utilizing a stronger currency to fend off inflationary pressures from soaring commodity prices. But the rise in the Euro/Dollar exchange rate still lags behind the increase in food and energy prices.

   As a result, inflation in the 15 countries using the Euro currency accelerated to 3.5% in March, a 16 year high that's even further above the ECB's long ignored inflation target of 2% per year.

   A stronger Euro is a blunt instrument for the ECB, because a weaker US Dollar also exerts upward pressure on crude oil and international commodities imported into the Eurozone. Therefore, although the ECB's repo rate is officially pegged at 4%, the ECB hawks have clandestinely pursued a quasi-tightening of monetary policy by allowing the three-month Euro Libor rate to climb to 4.75%, some 40 basis points higher than it usual spread to the repo rate.

   Setting the stage for the latest spike in Euro Libor rates, on Feb 27th Bundesbank chief Axel Weber signaled his support for lifting rates in Europe.

   "While recent price shocks have so far had only a small impact on expectations until now, that must remain the case in the future. If we were to see a clear upward trend, that would be for us a clear signal to act with monetary policy," he warned.

   "Market expectations that the European Central Bank will cut interest rates fail to consider the dangers of higher inflation. Be assured, our aim is and remains price stability in the medium term," Weber added.

   On March 12th, his sidekick Juergen Stark ruled out an ECB rate cut to cushion battered Euro zone stock markets. "This correction we are experiencing is necessary, it's painful and it's unavoidable. But I would warn against any knee-jerk reaction," he said.

   The upward surge in Euro Libor interest rates to 4.75% might have contributed to the stunning shakeout in the Gold Market from March 17th through April Fools Day. In the background, the New York Fed began shifting its tactics and lifted short-term US Treasury yields.

   But the Gold Price in Euros found an interim bottom at €560 an ounce, after the ECB capped the rise in the Euribor rates at 4.75% with open market operations to raise liquidity and cut the cost of borrowing.

More Toxic Losses to Come

   Goldman Sachs figures losses from toxic sub-prime mortgage debt at US banks could reach $460 billion, and only $120 billion have been recognized so far. Losses worldwide could hit $1.2 trillion.

   Such a meltdown could topple a few banks along the way, and unleash even more turmoil in global stock markets. So many traders are now betting that the G-7 central bankers and finance ministers will endorse a tax payer funded bailout for the banks, at their upcoming April 11th meeting.

   The earliest hint of a G-7 bailout plan was first proposed by Japan's financial services minister Yoshimi Watanabe on March 24th. "It is essential for the US to understand that given Japan's lesson, public fund injection into the financial sector is unavoidable. We could convey this lesson at the G-7 central bank meeting, and we are prepared to take coordinated action, to help resolve the issue," Watanabe said.

   Is speculation of a US government led bailout to rescue the banking industry a realistic proposition, or just a nasty April Fools joke? Washington might be left little choice but to lead a taxpayer bailout for banks choking on toxic sub-prime mortgages, because a rising tide of home foreclosures could crush the US economy without such a plan.

   There are hundreds of billions of Dollars worth of home mortgages in arrears, in foreclosure or that homeowners have walked away from. US Treasury Secretary Henry Paulson now says he's flexible to new ideas of intervention.

   Free market capitalism is out of favor in Washington, and in its place, government intervention is the norm of the day. Voters are demanding immediate help, especially after the Fed-engineered bailout of Bear Stearns and its massive financial assistance to other Wall Street dealers. The Bear Stearns bailout has opened the doors for US politicians facing re-election to call for bailouts of distressed homeowners.

   There is a long history of US government bailouts. In the late 1980s and early 1990s, more than 1,000 savings and loan institutions failed, leading to a federal bailout totaling roughly $125 billion. In 1975, President Ford provided a struggling New York City with a $7 billion loan package.

   President Clinton came to Mexico's aid in 1995 after a sharp devaluation of the peso, with $50 billion of loans.

   Congress bailed out Lockheed Aircraft in 1971 and Chrysler in 1979 with loan guarantees. In 1984, Continental Illinois was effectively taken over by the federal government. After the Sept 11th terror attacks, Congress authorized $5 billion in cash to help shore up the airline industry and $10 billion in loan guarantees. Most recently, the Bernanke Fed guaranteed $30 billion of toxic sub prime mortgage debt sitting in Bear Stearns, with taxpayer money.

   Just how costly a US government bailout to purchase existing sub-prime mortgage loans is anyone's guess, but it's probably much cheaper than the cost of the FDIC paying off depositors of failed banks. It would certainly be much less than the $845 billion that Congress has already appropriated for military operations, reconstruction, embassy costs, and US bases and foreign aid programs in Iraq and Afghanistan.

   A massive US government bailout would add hundreds of billions to the outstanding supply of US Treasuries, but greatly relieve the stress in the banking system. It could unleash a rapid unwinding of "safe haven" positions in US two-year T-notes, and lift US interest rates sharply higher.

   It could also trigger a reversal of the Fed's rate cuts since September and a tighter US money policy in the second half of 2008.

   With the yield on the US Treasury's two-year note jumping to 1.95% at the start of April, up from a record low of 1.35% two weeks earlier, it's already narrowed the scope of a Fed rate cut in April to a quarter-point.

   In testimony on Capitol Hill on April 3rd, Fed chief Ben Bernanke said, "The effects of monetary of policy are felt over a period of time and we expect to see positive effects of these policies going forward." Until then, Fed policy might stay on hold at 2% because, "there's a chance in the first half there might be a slight contraction," Bernanke said.

   Expectations that the Fed's rate cutting campaign is nearing an end have suddenly stabilized the US Dollar, with the greenback's strongest gains seen against the Japanese Yen.

   The Dollar – like the Yen – now offers negative rates of interest after adjusting for inflation. Yet the US currency has also risen strongly vs. the British Pound, currently with the highest G5 interest rates, in anticipation of gradual rate cuts by the Bank of England. The Bank of Canada is also expected to match any residual Fed rate cut in this cycle.

   The Gold Market was rattled after its historic rally fizzled out above the psychological $1,000 per ounce level in mid-March. Surprising moves by the Federal Reserve to drain some excess cash out of the US banking system after the rescue of Bear Stearns also dented the rally.

   But Mr. Bernanke and his radical band of inflationists at the Fed have expanded the MZM money supply by 16.8% from a year ago, which could ignite hyper-inflation in the US economy once the monetary stimulus in the pipeline starts to take effect.

   Crude oil remains perched above the once unthinkable $100 per barrel level, as global demand should outstrip supply later this year, and as global investors seek a hedge against the Fed's cheap money policies.

   So if a G7 government led bailout of the banks should fail to materialize, the Fed won't be able to rescue the Dollar with higher rates, and sentiment in the Gold Market could turn sharply bullish again.

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


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