At its most basic level, the U.S. Federal Reserve’s so-called “exit strategy” is designed to let government bailout and liquidity programs unwind on their own, as markets return to a state of “normalcy.”

But what investors don’t realize is that without an exit strategy that includes plans for unwinding insolvent mortgage giants Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) – now more accurately defined as government-sponsored hedge funds – recent market gains will be limited and will likely reverse. If those setbacks cause the nascent U.S. housing market rebound to stall, it could even lead to a decade-long downturn.

And Fed Chairman Ben Bernanke’s exit strategy ignores Fannie and Freddie.

The Government-Sponsored (800 Pound) Gorilla

When the U.S. government – succumbing partly to pressure from foreign bondholders – last September forced Fannie and Freddie into government conservatorship, it essentially nationalized what amounted to the world’s two largest hedge funds.

Essentially, in the government-brokered deal, taxpayers bought senior preferred stock (with a 10% annual dividend yield) from Fannie and Freddie, which each received $1 billion in capital. Both firms were also granted a backstop guarantee worth $200 billion. In March, amid escalating fears that these arrangements wouldn’t provide enough support, an additional $200 billion of taxpayer muscle was added to the support pyramid.

Why are we supporting run-amok government-sponsored hedge funds?

Describing Freddie Mac – and especially Fannie Mae – as “aggressively competitive” is a lot like calling the Grand Canyon “a ditch.” Both firms use their special status as “government-sponsored enterprises” (GSEs) to borrow trillions of dollars in the public markets – at spreads just a couple of basis points above U.S. Treasury debt.

This GSE status induced investors throughout the world – including virtually every major government- to load up on Fannie and Freddie debt, since that nurtured the belief these institutions were backed by the full faith and credit of the United States. As it turned out, any doubt about the status of GSE backing was put to rest. The September 2008 Congressional Research Service (CRS) Report for Congress – titled “Fannie Mae and Freddie Mac in Conservatorship” – plainly states that “the U.S. Treasury has put in place a set of financing agreements to insure that GSEs continue to meet their obligation to holders of bonds that they have issued or guaranteed. This means that the U.S. taxpayer now stands behind about $5 trillion of GSE debt.”

By borrowing cheaply and stymieing any threatening regulation by means of dispensing payoffs from its $350 million Fannie Mae Foundation – as well as from a 10-year, $170-million lobbying effort – Fannie and Freddie eventually managed to leverage themselves at a ratio of 60-to-one. Both firms successfully glad-handed powerful legislators into granting them clearance to keep expanding their balance sheets: Eventually, the two firms accumulated more than $6 trillion in mortgage balance sheet assets between them. The explosion of debt and leveraged assets was even more troubling because it came against a backdrop of lower and lower capital, the result of an ongoing relaxation of capital requirements, the specific result of targeted campaign donations

From Mortgage Facilitator to Financial Market Predator

Fannie and Freddie – with the GSE status acting as a U.S. government imprimatur – had easy access to cheap capital, and a massive leveraging capacity that would be the envy of even the most aggressive private-sector hedge funds. Does any one remember Long-Term Capital Management?

Together these two factors enabled Fannie and Freddie to buy back massive amounts of their own securitized pools of mortgage loans and – in a brazen money grab – to purchase huge amounts of private-label, bank-pooled securities that didn’t have their own mortgage-borrower guarantees. The game was about juicing up net-interest income by using cheaply borrowed money to buy high-yielding “junk” mortgages.

Originally, the term “hedge fund” applied to managers of alternative assets who once actually “hedged” their portfolios. Not only did Fannie and Freddie fail to hedge their rising risk exposure to any meaningful degree, they were insanely non-diversified, because they held only one class of assets: Mortgage-backed securities.

Despite such ill-advised strategies, the executive echelon at Fannie and Freddie paid themselves like private-sector hedge-fund honchos. In the middle part of this decade, Fannie Mae was involved in an $11 billion accounting scandal in which shareholders were allegedly deceived and regulators stonewalled. The company “managed” (manipulated) its quarterly earnings to smooth out returns and impress stockholders enough to induce them to drive its stock price higher and higher – a gambit designed to trigger big bonus payments for top executives.

Once a Vice, Now a Habit

In last week’s “Semiannual Monetary Policy Report to the Congress“ and in his July 21 Wall Street Journal Op-Ed piece, Bernanke, the U.S. central bank chairman, laid out plans to wind down government credit extension programs and combat any potential inflationary pressures. What was not addressed was how – or even if – the two government-owned and operated de-facto hedge funds, with combined assets of more than $6 trillion, would be unwound, or whether they would remain in place as they are in order to be used as back-door fiscal and monetary policy tools.

In what amounts to more than just a bailout on an unprecedented and under-reported scale, the takeover of both Fannie and Freddie provides the Fed and the U.S. Treasury Department a super sponge to both guarantee new mortgages and absorb all the unwanted mortgage-backed securities that banks and non-bank originators package and need to offload.

Because they lack sufficient capital – or lack the appetite to hold any new mortgage paper on their balance sheets – banks need this government-sponsored outlet for the mortgages they want to unload. The Fed and the Treasury Department are using their taxpayer-supported hedge funds to grease the rusted wheels of the mortgage money machine to gain traction where there is none.

The Housing Market is the Key to an Economic Rebound

Without a rebound in the U.S. housing market, most economists agree that the overall U.S. economy has almost no chance for a resurgence of its own. In fact, barring a turnaround in housing, the best we can hope for is to have the U.S. economy just limp along for years. And the reality is that without a resurgent housing market, the outlook for the general economy is actually much, much worse.

The prospect for a housing recovery is predicated on an end to the ongoing slide in real estate prices, followed by sufficient availability of low-interest credit – as well as a buying public that’s willing to use that credit to buy new homes if the cycle isn’t likely to repeat itself.

In an uncertain real-estate environment Fannie’s and Freddie’s wholesale purchasing of new mortgage pools is the only hope the U.S. government has of stimulating and accelerating the velocity of mortgage money. These hedge funds are now indispensable fiscal and monetary policy levers.

Beware of the “Bear Trap”

Propping up teetering banks may serve to shore up near-term public confidence in the financial system. But it also destroys the same system by dislocating any meaningful capital-allocation strategy by extending the life of sick institutions that suck up scarce resources. What’s happening at Fannie and Freddie is no different – except that it’s happening on an exponentially more debilitating scale.

As the buyer of last resort, the U.S. government is letting its two hedge funds continue to borrow and leverage themselves to backstop the nation’s mortgage-origination market. The Treasury Department also is buying up any mortgage-backed securities that Fannie and Freddie don’t add to their own balance sheets.

Taxpayers are being duped into believing that the mortgage market is recovering and that money will be flowing when they decide it is time to buy homes again.

But there’s a big problem here: At some economic “inflection point” – a point that will come together very quickly if interest rates unexpectedly spike – losses at the “twin terrors” of Fannie and Freddie could spike into the stratosphere, as well, meaning the financial reality that we’re detailing here will necessitate another bailout, but on a scale we’ve yet to envision.

In the first quarter alone, Fannie lost $23.2 billion – its seventh-consecutive quarterly loss – and it drew another $19 billion from its government piggybank. The firm has a negative-net-worth of $18.9 billion.

Fannie Mae isn’t just insolvent, it’s dead – though its functions are being maintained by a federal-government life-support system.

Freddie Mac had a $9.9 billion loss for the quarter and drew $6.1 billion from the U.S. Treasury. Freddie’s 10% dividend to the government on the $51.7 billion it has drawn to date is costing it $5.2 billion a year – an amount that exceeds what it earned in nine of the last 10 years.

Investors should be afraid. While the “bear trap” hasn’t been sprung yet – it’s clearly been set. Recently trotted out earnings that only look good because they exceed analysts’ doomsday estimates are not going to override the reality that mortgage financing won’t be easy or cheap when buyers return en masse. Unless our government weans itself off its own tainted tonic – and makes a concerted effort to create a financially viable private-sector mortgage-origination and investment outlet – the U.S. stock market will remain weak for decades.

Two Moves the U.S. Government Needs to Make Now

Unlike the unworkable plan that Bernanke outlined last week, there is an “exit strategy:” that will work. Government leaders need to understand that bigger is not always better, especially in light of the concentration of risk and taxpayer exposure that’s been created by these government-sponsored hedge funds. This exit strategy consists of two key initiatives:

• Get Competitive Again: Break up all the big banks and create a greater number of highly localized, community-centric banks. Let community and regional bankers securitize pools of mortgages using transparent “conforming” disciplines, and force originators and lenders to keep skin in the game. Create national ratings standards and let originators pool strictly defined, varying-quality loans into properly labeled packages, and let investors determine their risk tolerances without being blindsided. Large loans can easily be syndicated across multiple banking institutions and large risk-taking, non-deposit-taking institutions – such as real hedge funds and private-equity companies that will constitute the new “equity merchant banks” – can do a better job of high-stakes lending.

• Bring Down the Curtain on Fannie and Freddie: It’s time to break up Fannie Mae and Freddie Mac. The government has proposed reducing their portfolios by about 10% per year, but that’s not happening. In an end-around maneuver, while Fannie and Freddie are being propped up and still growing, the government is buying mortgages through the Federal Reserve. Either way, taxpayers end up holding massive pools of mortgages that no one else wants. Doing away with the socialization of homeownership financing will put the market back in control of appropriating risk.

The bottom line is this: The only “exit strategy” we really need is to position ourselves to diversify risk and promote stable rewards by taking apart what history has proven to be too-big-to-control.

Shutting down sick banks and unwinding government schemes to mask illiquidity will be painful and would certainly stress the financial markets again. But those are short-term pains that will lead to meaningful long-term change. On our current path, we may be keeping things copasetic in the near-term – but in the long run we remain on a potential collision course with some painful periods that will be deep and drawn out.

• The old adage tells us that “those who forget the past are doomed to repeat it.” After the tragic financial travails of the past year or so, the last thing the U.S. economy needs is to spring a bear trap that results in a 10-year financial malaise. Let’s learn from the mistakes  of the most-recent past and make the changes needed to avoid this pending dour outcome.

[Editor's Note: For additional insights on Fannie Mae and Freddie Mac, please click here to check out this additional story, which appears elsewhere in today's issue of Money Morning.

A new offer from Money Morning seeks to eradicate some of the economic uncertainty that's emanating from the ongoing climb in U.S. unemployment, and actually represents a two-part bargain for investors. The reason: It offers the new best-selling investment book penned by acclaimed financial commentator Peter D. Schiff and a subscription to The Money Map Report newsletter, a sister publication to Money Morning. Schiff's new book - "The Little Book of Bull Moves in Bear Markets" - shows investors how to profit no matter which way the market moves, while our monthly newsletter, The Money Map Report, provides ongoing analysis of the global financial markets and some of the best profit plays you'll find anywhere. To find out how to get both, check out our newest offer.]

News and Related Story Links:

• Money Morning Investigation of the Banking Bailouts:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• National Park Service:
  Grand Canyon.
• Wikipedia:
  Government-Sponsored Enterprise (GSE).
• Answers.com:
  Full Faith and Credit.
• Congressional Research Service (CRS) Report:
  “Fannie Mae and Freddie Mac in Conservatorship.”
• The Washington Post:
  Fannie Mae Shuts Down Foundation.
• The Street Authority:
  Junk Bond Debt.
• Wikinvest:
  Mortgage-backed Securities.
• The Free Republic (2006):
  Fannie Mae Manipulated Accounting (Trading Halted).
• USA Today:
  Fannie Mae whistle-blower feels vindicated by SEC decision.
• Money Morning News Analysis:
  Economic Outlook Improves, But Unemployment and a Possible Jobless Recovery Remain Wild Cards, Bernanke Warns.
• Money Morning Special Investment Report:
  Four Ways to Profit if Bernanke’s ‘Exit Strategy’ Backfires.
• Money Morning Mid-Year Forecast:
  Bank Stock Outlook: Will First-Half Gains Give Way to Second-Half Pain?
• Wikipedia:
  Long-Term Capital Management?
• Money Morning Market Commentary:
  Equity Merchant Banks: The Financial Sector’s Profit Powerhouse of the Future.

After more than a year of lax monetary policy and direct capital infusions, U.S. Federal Reserve Chairman Ben S. Bernanke has finally outlined an “exit strategy” that he says will lead to the “smooth and timely” withdrawal of monetary stimulus and keep inflation at bay.

However, analysts say that Bernanke’s exit strategy is far from foolproof and could touch off an inflationary firestorm that hammers the U.S. economy, debases the dollar and sends prices soaring.

Indeed, analysts have long been concerned that Bernanke’s unprecedented effort to boost market liquidity and expand the Fed’s balance sheet would lead to a significant increase in inflation once credit markets return to normal.

The Fed has injected more than $2 trillion into the U.S. financial system, expanding credit through increased loans to banks to provide liquidity. It’s also created the Commercial Paper Funding Facility – which holds $109.2 billion in short-term IOUs issued by corporations – and the Term Asset-Backed Securities Loan Facility (TALF) – which has lent $25 billion to investors to buy securities tied to auto and other consumer and business loans.

The Fed has also lowered its benchmark Federal Funds Rate to a record low range of 0.00%- 0.25%.

As a result, the U.S. monetary base has about doubled during the past two years.

Bernanke acknowledged in the Federal Reserve’s Monetary Policy Report to Congress – as well as in an op-ed piece in Tuesday’s Wall Street Journal and in comments made directly to the House Financial Services Committee – that inflation poses a significant threat. But he has also made it clear that the Federal Reserve has no interest in changing the course of its policy before it is certain that a recovery is underway.

“Economic policy conditions are likely to warrant accommodative monetary policy for an extended period,” Bernanke said in the Fed’s report to Congress.

Nevertheless, the central bank leader said he is confident that when the time comes he will have the “necessary tools” to rein in inflation in a “smooth and timely manner.”

So what is Bernanke’s exit strategy? Will it work? And what should investors do if it backfires?

Sign up below… and we’ll send you a new investment report for free: “Credit Crisis Report.”

A Look Inside Bernanke’s Toolkit

Bernanke has heard the concerns about inflation and this week he went a long way to address them. The Fed chairman not only addressed those concerns in his report to Congress, he penned an op-ed piece for The Journal.

Bernanke pointed out in each of those statements that some of the Fed’s emergency lending facilities automatically wind down as the economy recovers, because they have onerous pricing and terms.

Short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion from about $1.5 trillion at the end of 2008, he noted.

Additionally, Bernanke named two key measures that the Fed could take to raise market interest rates as needed and drain the central bank’s bloated balance sheet:

• Increase the amount of interest paid on balances held at the Federal Reserve by depository institutions (banks).
• Selling securities from the Federal Reserve’s portfolio with the agreement to buy them back at a later date.

The Federal Reserve last fall was granted the authority to pay interest (currently 0.25%) on the balances maintained by banks at the central bank. Raising the amount of interest paid, Bernanke argues, will give the Fed substantial leverage over the Fed Funds Rate and other short-term rates, because banks don’t typically supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve.

Basically, banks will be keener to keep their money at the central bank for a substantial, risk-free premium, than they will be to lend it out at a lower rate with a higher risk. And this can be done without draining reserve balances.

Bernanke noted that it’s common practice for many foreign central banks – including the European Central Bank (ECB), Bank of Japan (BOJ), and the Bank of Canada – to use their ability to pay interest on reserves to maintain a floor under market interest rates.

“Thus, the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the Federal-Funds Rate,” Bernanke argued in the The Journal. “Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.”

The second part of Bernanke’s exit strategy, which will be orchestrated in concert with the first, is to unwind the Fed’s balance sheet by conducting reverse repurchase agreements and outright sales of longer-term securities.

A reverse repurchase agreement is when the Fed sells securities from its portfolio with an agreement to buy them back at a later date.

“Reverse repurchase agreements, which can be executed with primary dealers, government-sponsored enterprises, and a range of other counterparties, are a traditional and well-understood method of managing the level of bank reserves,” Bernanke told the House Financial Services Committee.

Additionally, the Fed could simply sell its holdings in longer-term securities, which Bernanke says would drain reserves, raise short-term interest rates, and put upward pressure on longer-term interest rates by expanding the supply of longer-term assets.

“In sum, we are very confident that we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability,” Bernanke told the House panel.

Exit Strategy or Inflationary Quagmire?

At face value, Bernanke’s exit strategy is entirely plausible. But that doesn’t mean it’s foolproof. There are a number of lingering questions and concerns still lingering in the minds of many investors and analysts.

First, there is a question of timing. Bernanke may have described the Fed’s tools, but he did not define the conditions that would lead to their use. That is, at what point does inflation become enough of a concern, and at what point does U.S. growth become sustainable enough, to warrant a change in Fed policy?

Bernanke sent a clear message to the market this week that he is aware of the potential risk of inflation, but he also made it clear that the economy is still in need of nursing. What Bernanke termed “accommodative monetary policy” – interest rates near zero and capital infusions through the purchase of government and mortgage debt – likely will remain the norm for the foreseeable future.

That seems fair considering that inflationary pressures have remained low, bank balance sheets are still in disrepair, consumer spending is weak, and unemployment is the highest it’s been in decade. But as the economy improves, the central bank’s policymaking Federal Open Market Committee (FOMC) will have to come to a consensus about when stimulus should be retracted and liquidity tightened.

“Because there is no clear model or indicator on what tools to exit with, that is where the fuzziness is,” Rudy Narvas, senior analyst with 4Cast Ltd. in New York, told Reuters. “If you don’t time it right, either you dip the economy back into recession, or you will fuel the inflationary fires.”

But timing isn’t the only uncertainty regarding the Fed’s plan. There are also questions about how effective the Fed’s “tools” will be.

Raising interest payments on reserves could entice banks to keep more money with the Fed, but there’s a limit as to how much money the central bank can pay out.

“There will eventually be a situation where the Fed is paying the banking system something like 5% on $700 billion of reserves,” Bank of America-Merrill Lynch (NYSE: BAC) rates strategist Michael Cloherty wrote in a research note. “That would mean the Fed would be paying the banking system $35 billion per year of what is ultimately U.S. taxpayer money in order to push up interest rates.”

Reverse purchase agreements could help trim the Fed’s balance sheet, but the primary dealers – the “government-sponsored enterprises,” and a range of other counterparties that Bernanke referred to – would have to have healthy balance sheets of their own. And so far there’s no indication that they will.

Even selling longer-term securities outright carries an inherent risk. Merrill Lynch estimates that the Fed will hold $1.25 trillion in Treasury, agency, and private mortgage-backed debt.

The Federal Reserve “can’t fob huge amounts of paper onto the market without having some seriously detrimental implications for long-term rates,” Alan Ruskin, international strategist at RBS Securities (NYSE ADR: RBS), told Reuters.

The worst-case scenario, according to Ruskin, would be if foreign holders of U.S. debt – such as China, which held $768 billion of U.S. securities in reserve at the end of March – started dumping Treasuries and the dollar, causing a currency crisis.

What to Do if Bernanke’s Exit Strategy Backfires

If the Fed is too slow in its withdrawal of “accommodative monetary policy,” or if the central bank finds itself unable to unwind its balance sheet in as “smooth and timely manner” as Bernanke anticipates, a major surge in inflation will be likely the result.

In that case, one of the clear winners would be commodities – especially gold.

“Protection from inflation is a huge benefit to commodities,” said Money Morning Contributing Editor Peter Krauth. “Specific investments would include gold, silver, oil, and copper, to name a few. All of these are valuable – and possess an actual value – which means that they will not go to zero. Since they are priced in U.S. dollars, as the dollar loses value through inflation, you need more dollars to buy the same quantity (not to mention increasing demand).”

If you’re interested in purchasing gold, you could do so by purchasing bars, or bullion, or though the gold-linked, exchange-traded fund (ETF) SPDR Gold Shares (NYSE: GLD).

Today, SPDR itself holds more than 1,000 tons of gold, and has a market capitalization of $33 billion. The fund’s price fluctuates in concert with the price of gold, which adds a small mount of risk. However, buying this ETF is more convenient than buying gold bars directly, because the fund dispenses with the accompanying storage problems that comes with actually owning physical gold.

Similarly, there are other commodities-based ETFs that would offer a significant return should inflation take hold.

For instance, the United States Oil Fund LP (NYSE: USO), the iPath S&P GSCI Crude Oil Total Return Fund (NYSE: OIL), or the United States Gasoline Fund LP (NYSE: UGA) all offer exposure to oil and gas prices, which have surged recently on demand but are certainly responsive to inflation as well.

[Editor's Note: If it's inflation you're worried about - and commodities you want to invest in - there's no better place to look than the Global Resource Alert trading service, which ferrets out companies poised to profit from the so-called "Secular Bull Market" in commodities. If you're new to the commodities-investing arena, and are uncertain about the landscape - or even if you're an "old hand" at natural-resource stocks, but want some insights into the new profit plays and new players - consider hiring a guide: Money Morning Contributing Editor Peter Krauth, a recognized expert in metals, mining and energy stocks, who is also the editor of the Global Resource Alert. A former portfolio advisor, Krauth continues to work out of resource-rich Canada, which keeps him close to most of the companies he researches. Against the growing global financial malaise, Krauth says that commodities are among the most-profitable and least-risky investments available, and notes that this may well be the most powerful bull market for commodities we'll see in our lifetimes. He makes a strong case. To read more about his strategies, and the sector plays he likes the most, please click here. ]

• Wall Street Journal:
  The Fed’s Exit Strategy
• CNNMoney:
  Text Of Fed Bernanke’s Prepared Remarks To House Panel
• Reuters:
  Bernanke reassures markets but doubts remain
• Money Morning:
  Geithner Opens Up Debt Dialogue With China, but the Dollar Still May be Doomed
• Money Morning:
  Economic Outlook Improves, But Unemployment and a Possible Jobless Recovery Remain Wild Cards, Bernanke Warns
• Money Morning:
  With Inflation on the Horizon, Gold Prices are Ready to Rally
• Money Morning:
  Commodities: The One Profit Play Investors Can’t Afford to Ignore.
• Investopedia:
  Reverse Purchase Agreement.
• Wikipedia:
  Government-Sponsored Enterprises.

In holding overnight rates steady at 2%, the U.S. Federal Reserve once again put forth its belief that, despite a cascade of horrific financial data, the economy is likely to continue to grow slowly and that inflation would moderate. 

Although wrong on both counts, this view is consistent with the relative optimism that prevails across the country. After nearly two decades of an uninterrupted consumption binge, most Americans simply refuse to believe that anything can seriously derail the American economy. It’s a pleasant dream, but the wakeup call can’t be too far off.

The benign outlook on inflation is rooted in the hope that a slowing economy will pop the commodities “bubble” and break the back of inflation. Despite these pronouncements, most rational observers understand that inflationary pressures are currently intensifying, not abating. Rising commodity prices are not the cause of inflation, but merely the symptom of rampant monetary expansion from the Fed and other central bankers around the world. 

By all indications, the liquidity injections are about to shift into a higher gear. The recent housing bailout bill is the most inflationary legislation ever enacted and there is already talk of yet another economic “stimulus” bill.  The new money creation needed to finance these schemes, together with exploding federal budget deficits, will not only reverse the recent declines in commodity prices, but send other consumer prices soaring as well.

It is also worth noting that a slowing economy does not, by itself, bring prices down.  If it did, prices in Zimbabwe would be falling. When combined with responsible monetary policy, a growing economy would tend to push prices lower (based on greater productivity and expanded supply).

As far as the economy avoiding a recession, the chances of that are fairly close to nil.  In fact, if the government reported legitimate gross domestic product (GDP) numbers, the recession that is already being felt on a gut level would finally be officially recognized.

One reason for the apparent optimism on the economy is the belief that the housing market is nearing a bottom. Every step down the housing abyss seems to convince more and more people that the bottom is in. The recent Case/Shiller Home Price report, which showed that real estate prices have now returned to 2004 levels, is the latest piece of such “good” news. 

In fact, a new national survey by real estate website Zillow.com found that 62% of U.S. homeowners believe that their home is worth as much or more than it was a year ago. Three-quarters of those surveyed expected that the value of their homes would rise or at least stay the same between now and early 2009. Talk about a field of dreams!

However, given the horrific fundamentals of the market, I would expect that before the market finds a real bottom, another four years of price increases will be similarly erased; leaving prices at 2000 levels or lower. Although this prognosis may seem dire, it is nonetheless reasonable when you consider the current supply/demand dynamics.

Despite the sentimental hope that homes are worth what they cost to build, or what the last buyer paid, in reality they are determined simply by supply and demand.  In this case the supply of homes on the market, and the number and motivation of potential homebuyers.

First supply: In 2008 there are more vacant and “for sale” homes on the market than there have ever been. In the last few years, despite signs of a coming real estate bust, the nation’s largest homebuilders kept building. As a result, hundreds of thousands of unwanted homes were added to the market. These homes, combined with the existing homes that underwater mortgage holders are desperate to sell, add up to unprecedented supply. Inventory at the current sales pace is approaching a one-year supply.

The demand side is even worse. In real estate, a buyer’s expectations for future price gains and their ability to obtain a mortgage (with as little money down as possible) largely determines demand.  It is telling that the price increase optimism of current homeowners does not extend to current homebuyers.  Also, with lending standards finally being tightened, buyers do not have access to the cash to bid up prices. Many are taking advantage of a still attractive rental market to sit on the sidelines.

These dynamics are actually much worse than what were in place in the summer of 2000 when the home price boom was still in its opening innings.  All of the factors that were in place to push home prices up to unsustainable levels (unlimited lending, massive speculation, widespread belief in the indestructibility of home prices) are all gone. Prices will continue to fall until all the gains sparked by these forces have been erased.    

The reckless optimism displayed by the Fed and current homeowners has proven extremely resilient. But sooner or later reality must intrude. Once the wake-up call sounds, the economic effects will be severe. 

Once homeowners realize that their equity is gone, and not likely to return, what incentive will many have to continue making burdensome mortgage payments?   With a new wave of option adjustable rate mortgages (ARMs) about to reset, this Christmas it will be the mail, not the bells, that will be doing most of the jingling.

[Editor’s Note: Peter D. Schiff, Euro Pacific Capital Inc.’s president and chief global strategist, is a regular contributor to Money Morning, and most recently wrote about how former Federal Reserve Chairman Alan Greenspan is now criticizing the very housing bubble that he actually helped create. That housing bubble is feeding right into the looming “SuperCrash.” To find out how to get a report on the once-in-a-lifetime profit plays that will emanate from this so-called "SuperCrash" – which comes with a free copy of Schiff’s New York Times bestseller "Crash Proof: How to Profit from the Coming Economic Collapse" – please click here.]

News and Related Story Links: 

• Money Morning Commentary:
  Ex-Fed Chief Greenspan Changes His Tune and Blasts the Housing Bubble He Helped Create.

• The Associated Press:
  Official Zimbabwe inflation at 2.2 million percent

U.S. Federal Reserve Chairman Ben S. Bernanke and his fellow central bank policymakers will be back in the spotlight this week as the group convenes for its monthly monetary-policy meeting.

But there won’t be much to report.

Although the Federal Reserve’s policymaking Federal Open Market Committee (FOMC) meets Tuesday, the group doesn’t have much room to maneuver: If the Fed cuts rates to stimulate growth, already troublesome inflation could escalate out of control. But if the FOMC raises rates to reign in inflation, the entire economy could drop into a deep-and-lingering recession.

To be sure, Fed policymakers are sure to engage in some spirited debate: The debates will include such topics as pricing pressures vs. slow growth and strong energy prices vs. the weak housing market. There will even be talk about extending the emergency-borrowing program, or about expanding oversight over financial-services firms.

But if Federal Reserve policymakers do much of anything more than just debate the issue – and try and take some kind of action, using interest rates as their weapon of choice – there’s almost certain to be a negative impact on the U.S. economy.

The data coming out this week will focus on the consumer as personal income/spending and consumer credit reveal just how active folks have been during these uncertain times.  As the summer (of discontent) winds down, travelers may be able to get in a last minute trip or two as gas prices have declined over the past few weeks.  And retailers are hoping to benefit from the “back to school” shopping crowd. And second-quarter earnings reports continue as consumer giant, The Procter & Gamble Co. (PG), and insurer American Insurance Group Inc. (AIG) headline the reporting companies.

The final question: Will there be any new surprises as the season comes to a close?  

Market Matters

As earnings season plugs along, just as many questions and concerns about the strength of Corporate America remain unanswered as when Alcoa Inc. (AA) was first on the clock a few weeks back.

At mid-week last week, just over half of the Standard & Poor’s 500 Index companies had reported and the results actually looked halfway decent (relatively speaking, that is).  About two-thirds of those companies announced earnings that exceeded expectations, while only 20% or so missed on analysts’ targets. 

Financials dominated the “good” news companies, as four of the five leading banks bested Street estimates (though, that often meant lower losses instead of better profits).  However, when the dust finally settles, the second quarter will represent the fourth-straight period of declining earnings as S&P companies are headed for a double-digit drop from last year.

Of course, the massive plunge among financials greatly contributed to the negative results.  Looking forward, the eternal optimists remain confident that positive earnings will return for the second half of the year. These optimists even believe that the financials may lead the way as commercial banks and investment banks finally move beyond the period of “never-ending” write-downs.  However, if such optimism does not come to fruition and annual earnings decline for the second full year in a row, Corporate America will have accomplished something not experienced in quite a while – not even during the bear market (and recession) of the early 2000s. 

So, let’s review last week’s numbers.  Energy companies benefited from the surge in oil and gas prices as Exxon-Mobil Corp. (XOM) posted the best quarter ever by a domestic company (though it still managed to fall short of Street expectations). Royal Dutch Shell PLC (RDS.A, RDS.B) and Chevron Corp. (CVX) reaped some strong results as well [For a related story on Exxon and Shell, please click here. For Money Morning‘s recent “Buy, Sell or Hold” feature on Chevron, please click here].

United States Steel Corp. (S) took advantage of the rise in commodity prices, while Verizon Communications Inc. (VZ) and Motorola Inc. (MOT) both recognized better-than-expected profits.  On the downside, General Motors Corp. (GM) experienced its third-worst quarter ever. Tyson Foods Inc. (TSN) struggled as increased grain prices hindered chicken sales.  Sony Corp. (ADR: SNE) was victimized by a decline in consumer spending.  And one-time telecom-sector darling Alcatel-Lucent (ADR: ALU) reported another terrible quarter and said goodbye to both its chairman and its chief executive officers at the same time.

Shifting to the financial world (where there’s no rest for the weary), Merrill Lynch & Co. Inc. (MER) plans to write-down another $5.7 billion as it sells off much of its underwater mortgage portfolio and looks to raise another $8.5 billion through a common stock issuance.  (Some analysts believe Citigroup Inc. (C) has another $8 billion in write-downs in it, as well).  First National Bank of Nevada and First Heritage Bank joined IndyMac Bancorp Inc. (OTC: IDMC) as they were taken over by the Federal Deposit Insurance Corp. (FDIC).

Volatility emerged in the energy market as oil prices fell to their lowest level in two months and even declined in July by almost $16 a barrel from previous record highs.  A late-week rally pushed prices higher, though the general trend may have shifted.  Some untimely comments from the Organization of the Petroleum Exporting Countries (OPEC), and turmoil in Nigeria (not to mention Iran) threaten to shift that newly upbeat mood back into a negative one.

Gasoline fell below $3.90 a gallon after hitting a high of $4.11 at mid-month.  Stocks experienced quite a bit of volatility as daily triple-digit price movements (up or down) seem to have become the norm.  Weaker economic data (see below) helped end last week on a sour note, while bonds benefited from a flight-to-quality that sent the yield on the 10-year below 4% again.  All in all, another ho-hum summer week (if +/- 200 daily price moves can be considered ho-hum).                                     

Economically Speaking

Economists got their first look at the overall growth numbers for the second quarter as Gross Domestic Product (GDP) climbed by 1.9% during the three-month period.  While the data seemed to put the economy safely out of recessionary territory (for now), analysts actually had been hoping for a 2.4% growth rate on the heels of the tax rebates that arrived in May.  The eternal pessimists remain fearful that subsequent quarters will prove far weaker without any additional economic stimulus plans.

Consumer confidence rebounded (ever so slightly) from a 16-year low as declining energy prices eased the prior inflationary fears.  Activity within manufacturing was reported right at the “boom/bust line” of 50 as the Institute for Supply Management ISM Index indicated neither expansion nor contraction during July.  Construction spending fell again (the 11th month of declines in the past 13), proving that the country will not be experiencing a housing rebound anytime soon.   

All eyes were on the labor picture as economists hoped that the domestic layoffs were starting to subside and college grads would be joining the summer work force just in time to stimulate growth.  Early in the week, the Automated Data Processing (ADP)/ADP Survey indicated that private sector employment was on the rise and 9,000 new jobs actually had been added to the economy.  Unfortunately, the euphoria was short-lived; on Friday, the unemployment rate was reported at 5.7%, its highest level in four years.  Meanwhile, 51,000 jobs were lost from the labor force, the seventh-straight month of a shirking non-farm payroll picture.  While the July cuts were slightly below expectations, analysts could not help but focus on the fact that more than 460,000 jobs have been eliminated so far this year. 

Weekly Economic Calendar

News and Related Story Links:

• Money Morning News Analysis:

  Exxon Mobil and Shell Post Record Income but Demand and Production Weigh on Shares.

• Money Morning Special Investing Feature:

  Buy, Sell or Hold: Chevron Corp.

• The Financial Times:

  Alcatel-Lucent chiefs to step down.

• Money Morning Economic Analysis:
  2Q GDP Buoyed by Exports and Rebate Checks.

By Shah Gilani
Contributing Editor

Given that the U.S. Federal Reserve is the master of “Three-Card Monte,” can you tell what’s in the cards for short-term interest rates?

Three-Card Monte is a confidence game in which manipulation and misdirection are employed as the “mark” tries to guess where the “money card” is among the three facedown choices.

The Federal Reserve’s job is to masterfully manipulate the public’s perception of where interest rates are headed. And it runs this larger-than-life game with three specific face cards:

• Inflation.
• The U.S. dollar.
• And the actual “money card,” which is interest rates.

For the Fed, the end game is public confidence itself. The central bank actually intended to gain and keep our confidence in its ability to stem inflation and strengthen the greenback. And it pursues these two objectives by simultaneously managing the direction of interest rates and working to keep the economy from dropping into a recession, or worse, a depression.

The Fed and the Global Game of Dealer’s Choice

First, ladies and gentlemen, please take a good look at the inflation card. What we have here is the Jack of Spades, the rising inflation card, and a devilish villain whose prospects instill fear in all the world’s central bankers – not to mention the public at large. But remember that real inflation is initially trumped by inflationary expectations. Here’s what that means: No matter how bad inflation gets when it rears up, this tsunami of swirling prices doesn’t really reach shore and inflict damage until there is a pervasive expectation of its arrival.

It’s here that the perception about the potential impact actually begins to take hold and starts changing our behavior.

If a loaf of bread costs $2.00 today and $2.50 tomorrow, is that a problem?  Let’s assume that prices for some other things are rising, too. That may or may not be a problem; it depends on what you are buying. But if you look at the increase in those items that have risen in price, you can raise the specter of impending inflation. The question to ask is this: Is it affecting you?

Prices rise and fall based not only on the supply and demand for our loaf of bread, but also on the same catalysts for the underlying ingredients and labor that go into that bread loaf.

If increases in those costs are passed along in the form of higher prices for the finished product, then we will pay more. But we may no longer have a need to purchase that loaf of bread, or we may have substitution possibilities that are not as costly. Inflation is only a problem if there are a lot of goods and services for which there are no substitutes, meaning that we have to pay those passed-along higher prices for such “essentials.”

It is therefore the expectation of inflation across a wide spectrum of mostly essential goods and services that begets real inflation. And as we’ll see shortly, it’s a viciously virulent circle. If prices rise and we cannot afford the goods and services we demand, we will seek higher wages to be able to finance this newfound higher cost-of-living. If we achieve higher wages to pay for the higher cost-of-living, our employers’ profit margins are crimped and they have to charge more for the goods and services we produce for them so that they can pay us.

Finally we have a “real” problem – “real” inflation. And it’s quite a hand to be dealt.

But beware of the trickery being played upon us. Let’s take a look to see what I mean.

Watch for the Fed’s One Hellacious Hole Card

The first card of the three to be played is the Jack of Spades – the card the Fed shows us when it acknowledges its own inflationary worries. Central Bank Chairman Ben S. Bernanke & Co. show us that card because it’s meant to tell us: “We have to raise interest rates to stamp out your expectation that inflation is taking root.”

That’s an important part of the central bank’s hand. But here’s a secret those of you who aren’t yet initiated in this confidence game probably aren’t aware of: The Fed doesn’t really have to actually raise interest rates, since the mere expectation the central bank is going to act is enough to change individual behaviors and alter market trends.

Second, ladies and gentlemen, we have the Jack of Clubs – the falling-dollar card, another devilish villain. Take a good look, folks: The prospect of a falling dollar means that – relative to other currencies and other economies (Europe, China, India, Japan and South America, to name just a few), America’s worth is declining.

The falling-dollar card also points to increased inflation. Why? Because the more the greenback declines, the more it costs us to buy the goods and services we get from all of our trading partners.

Additionally – and much more insidiously in nature – the value of all the dollars that our trading partners hold is falling, meaning that the buying power of their dollar reserves are in decline, as well. That’s a problem for many reasons, not the least of which is that their stronger currencies allow them to buy U.S. assets at bargain-basement prices. Indeed, it’s already happening, as we see from all the foreign takeovers of U.S. companies, and from Dubai’s recent buyout of New York’s Chrysler Building.

Moreover, since most of the world’s commodities – especially oil – are priced in dollars, it takes more and more dollars to pay for those commodities. And with oil, the producers are loath to see their petro-gusher revenue decline. So with every downward click in the dollar, there’s a corresponding upward click in the per-barrel price.

If that doesn’t represent inflation, nothing does.

For the Fed, then, the Jack of Clubs is the card the central bank is now waving to say: “We have let the greenback fall far enough and we are ready to support our dollar and strengthen it.”

At this point, the only real way to strengthen the dollar is to raise interest rates.

So, my good friends, just where is that third card, the Queen of Hearts, the interest rate card? In which direction are rates going?

The Queen of Hearts is nowhere in sight.

The confidence game now demands that the Fed take action against inflation and strengthen the dollar. The two Jacks are the cards central bank policymakers are energetically and enthusiastically waving in our faces. But it’s misdirection – that’s the game.

By waving those two cards, the Fed implies that interest rates must rise to stem inflation and support the dollar.

But rates cannot rise. The game is fixed. And most investors don’t even realize it.

The Fix Is In

The Fed is not really worried about inflation (on a relative basis). It’s true that inflation has reared its ugly head, and is inflicting both damage and pain on the U.S. economy. But the collective expectation for inflation and its resulting pressures are not here yet. The Fed knows that as we are falling deeper into recession, jobs will be lost, wages will not rise, consumers will not be buying. There’s no real need to raise rates. The central bank just needs to show us that it has that card; it’s part of the game. It’s about giving us confidence in its resolve to do battle with the evil forces of inflation.

The same is true of the Fed and the dollar. It’s only been in the past couple of weeks that the current “Bush-league” administration and the Fed have even acknowledged the dollar’s big swoon. Why the delay? Because they knew consumers were tapped out and that the only growth (which they point to as part of their confidence-building shell game) is being generated by exports. The dollar has fallen so far that our U.S.-made goods and services are essentially “on sale” when compared to wares made in countries whose currencies have zoomed to record highs against the greenback.

I hope I’m not confusing you. But if you are a bit bewildered, let me provide the “spoiler” here by telling you precisely why the “money card” stays face down: Interest rates cannot go higher.

The credit crisis has blown our banking system apart, and the fallout from that explosion has smashed our entire capital formation/borrowing & lending infrastructure. And the capital that formally emanated from that sophisticated system is what makes the merry go round.

Rates now have to stay low in order to jump-start these crucial liquidity flows and re-ignite demand. While it’s true that maintaining low interest rates will further fuel inflation, the Fed really has no choice. Or perhaps it’s a Hobson’s choice. You see, if the central bank actually raises rates to combat inflation, adjustable rates on mortgages will rise, setting in motion a whole new round of housing defaults, which will lead to an escalation of bank write-downs, which will torpedo stock prices, which will force institutional investors to liquidate holdings to raise capital. The same will happen out in the marketplace, where companies with debt coming due will find it impossible to refinance, touching off still another avenue of defaults, losses, and write-downs.

Better to keep rates low now – and believe that it can throttle back inflation later on.

Beware of the proverbial dead-cat bounce. Keep your eyes on the prize. There will be a market bottom. It’s not clear how long that will take. But keep this in mind: It won’t be a buying opportunity until the “shills” have been shaken out and “the game” the Fed is playing is no longer a confidence game, but instead is the kind of transparent, well-supervised marketplace that’s the hallmark of capitalism.

News and Related Story Links:

• Money Morning Special Report:
  Special Report: Are We Now Running With the Bulls, or Just Following More Bear Tracks?

• Wikipedia:
  Three-Card Monte.

• TopNewsIn:
  Dubai buys New York’s landmark Chrysler Building.

• Money Morning Financial Commentary: The Lost Decade: How the U.S. Financial Crisis Resembles Japan’s Ten Years of Misery – And How to Play it (Part I of II).
• Money Morning Financial Commentary:
  The Lost Decade: How the U.S. Financial Crisis Resembles Japan’s Ten Years of Misery – And How to Play it for Profit (Part II of II).

• Wikipedia:

  Shill.

• Money Morning Financial Commentary:

  Inside Wall Street: That Ticking Sound You Hear Out in the Mortgage Market is the FHA.

• Wikipedia:

  Hobson’s choice.

• Wikipedia:
  Dead-cat Bounce.

U.S. Federal Reserve Chairman Ben S. Bernanke ignored the warnings of most economists last week, and kept the benchmark Federal Funds rate at 2%, far below the actual rate of inflation.

As a result of this non-move, investors can probably look forward to having global commodities boom to continue for at least a while longer.

Here’s why.

Genesis of a Commodities Boom

Although the overall commodities boom has been under way for a number of years, prices didn’t just move up in a straight line: There have been long stretches during which prices advanced sharply, followed by short stretches of volatile prices reversals.

The latest advance – and certainly one of the most intense – was ignited Sept. 18, which is when the U.S. central bank embarked upon one of the most aggressive rate-cutting campaigns in its history, slashing short-term rates from 5.25% to the current 2.0%. Since the rate cuts began, the Reuters/Jefferies CRB Index of commodity prices has jumped 32%, from 435 to 572. Oil is up from $82 to $143 per barrel, a rise of 74%. And gold has moved rather modestly, from $770 to $928 per ounce, a mere 21%.

The reason for this intense advance in commodity prices is that the Fed and its European counterpart have been pumping money into their respective economies to prevent the collapse of several major banks.  The St. Louis Fed’s “Money of Zero Maturity” (the best broad money-supply measure left over since the central bank stopped reporting M3 money-supply statistics in March 2006), is up at an annual rate of 17.6% during the last six months. In Europe, Euro M3 is up at an annual rate of 10.8% during the same period – still double the growth seen in nominal gross domestic product (GDP).

In the key emerging markets, the money supply has been rising even faster – 19% in China over the past year, and 21% in India. Not surprisingly, those countries’ inflation rates are taking off, with India into double digits and China quickly getting there.

Igniting Inflation

In the U.S. economy, inflationary pressures are just beginning to show themselves.  Producer price inflation (PPI) was 7.4% over the 12 months to June. Consumer price inflation rose 0.6% in June – and 7.5% annually – after it previously had been held down by a number of strange-looking “seasonal adjustments.”

But even if the inflation rate is truly only 4%, the Fed’s monetary policy is dangerously inflationary; if it is actually 7%, giving a real Fed Funds interest rate of minus 5%, then prices can be expected to take off like a rocket – as they are already in the commodities market.

Bernanke issued stern warnings before last Wednesday’s meeting of Federal Open Market Committee (FOMC) policymakers, talking about the dangers of inflation and the need to preserve a strong dollar. For the first time, large numbers of mainstream economists echoed his warnings – even Larry Kudlow, one of the strongest proponents of the Fed’s initial rate cuts last September, was spooked by the inflationary prospects.

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After the meeting, however, Bernanke did nothing but issue a further warning.

It’s highly unlikely that he’ll raise interest rates before Aug. 5, which is when the Fed next meets. That’s because, having ignored the warning of June’s consumer price index (CPI), Bernanke is unlikely to be pushed into raising rates by a second bad inflation number in July.

In fact, he’s more likely to cut rates than to raise them – but only in the face of a major crisis.

Any “crisis” would probably take the form of a banking collapse, or a serious deterioration in the U.S. economic position, in which case Bernanke might well be forced to cut rates again.

Thus, for the next several weeks, it’s highly likely that the commodities “bubble” – which is clearly what this has become – will grow in both size and scope.

So now that we know that, the question to answer is clear: How do we profit?

Bubbles, Doubles, Oil and Troubles?

It’s fairly clear to me that concerted speculation by hedge funds and pension funds is what’s been pushing up oil prices. But that may be playing out – and reaching its limit – as the huge price increases we’ve seen in “black gold” over the past year is finally dampening consumer spending both here in the United States and in other key markets worldwide. So the oil patch may be too slippery a spot to play right now.

On the gold front, if there is concerted action it is by central banks that are trying to suppress the advance in the price of the so-called “yellow metal.” Unlike oil, there is no natural dampening of demand for gold as the price rises; speculative demand (the major factor) tends to intensify. Moreover, an economic recession, which would probably be accompanied initially by inflation that was still accelerating, could intensify the rise in the price of gold, instead of suppressing it.

Investing in the late stages of a bubble is highly speculative. Nevertheless, I reiterate my prediction of a few months ago that gold will reach $1,500 an ounce. Even if the Fed begins to act against inflation in August, it is very unlikely that its initial actions will be effective. Don’t forget that in the last great inflationary bubble of 1980, gold hit a level that’s the equivalent of $2,300 an ounce in today’s money.

I would consider SPDR Gold Trust (formerly StreetTracks Gold Trust) shares (GLD) about the most efficient way of getting a pure gold play. As an alternative, you might consider a silver investment: The metal is currently trading at less than 15% of its 1980 high, the equivalent of $130 per ounce. If that’s a move you like, the iShares Silver Trust ETF (SLV) seems the best way to play silver directly.

News and Related Story Links:

• Commodities Research Bureau:
  CRB Indexes.

• Money Morning Special Investment Research Report:
  Six Ways to Play Money Morning’s Prediction That Gold is Headed for $1,500 an Ounce.

• InflationData.com:
  Goodbye M3 – What is the Government Hiding?

By Peter D. Schiff
Guest Columnist

Ever since Robert Rubin began the tradition in the mid-1990s, it has been a significant element of the U.S. treasury secretary’s job to continuously state that a strong dollar is in the national interest. It is widely regarded that such utterances, if repeated often enough, can constitute the sum total of what is still laughingly known as the nation’s “strong dollar policy.”

Over the past two generations, the American government has launched many failed “campaigns.” To list just a few, there has been the “War on Drugs,” the “War on Poverty,” and the continued attempts to improve education. But the strong dollar policy must be seen as the poster child for all failed Federal policies. However, many in the market took cheer that the policy is now being greatly expanded. In an unprecedented move, U.S. Federal Reserve Chairman Ben S. Bernanke is now adding his voice to the chorus and using the same rhetoric previously used by the treasury secretary alone. That’s two people saying the words…not just one. A double-barreled, strong-dollar policy!

A New Game Plan?

As the administration is so fond of saying, a nation’s currency reflects the underlying strength of its economy, and in that sense can be seen as a nation’s economic report card. In truth, a strong currency is in the interest of every nation, just as good grades are in the interest of every student.  Using this basic analogy, a flunking student cannot improve his grades by simply telling his parents, teachers, and fellow students that he has adopted a “straight ‘A’ policy.” If his words are not accompanied by an actual change in behavior – whereby he stops cutting class and starts studying more – his new policy is unlikely to achieve results. So long as his bad habits persist, the policy will not be any more effective simply because one of his friends chimes in.

In his speech last week, Bernanke finally admitted that the weakness in the dollar was contributing to both higher inflation and elevated inflation expectations. This stands in stark contrast to his recent testimony in front of the House Banking Committee, where in response to a question asked by U.S. Rep. Ron Paul, Bernanke confidently declared that the weakness of the dollar only affected Americans who travel abroad. It is amazing how little attention this complete reversal received.

The media of course wasted no time in declaring that Bernanke’s speech heralded the opening of a new front in the campaign against the falling dollar.  For example, CNBC’s Larry Kudlow proclaimed that Bernanke had endorsed “King Dollar” (someone needs to remind Kudlow that the king has long since abdicated his throne) and the network ran an entire segment on how to profit from the new dollar rally [Money Morning, of course, warned readers that this "dollar rally" was actually a "head fake of legendary proportions"].

All of this because Bernanke merely mentioned the dollar, acknowledged its effects on inflation, and expressed concern for its plight. As far as the media and Wall Street are concerned, words without action are enough. Too bad that’s not the way things work here on the planet Earth.

Investors received an encore performance yesterday (Tuesday), when bond, currency and interest-rate markets reacted very strongly to comments that Bernanke had made the night before: Investors took his inflationary concerns as a very clear signal that short-term interest rates will likely jump this year [again, something Money Morning has already been predicted].

The Doomed Dollar?

The real take away from Bernanke’s comments is not that the dollar is about to rally, but that it is now more likely to sink even lower.  I believe the main reason Bernanke has refrained from mentioning the dollar in the past is that he did not want to be put in a position of actually having to do something about its decline.  He is now so fearful of an imminent dollar collapse that he must have felt compelled to throw down the gauntlet – despite his very real fear that someone might actually pick it up.

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My guess is that currency traders will ultimately see this as an act of desperation. When the dollar keeps falling, there will be a chorus of demands that the Fed put some real teeth in its new policy.  If Bernanke does nothing, the world will finally see a naked emperor and the dollar’s decline will turn into a rout.  If, on the other hand, the Fed raises interest rates to defend the dollar, and only a short-term bounce results, then all remaining confidence in the Fed’s ability to support the dollar will evaporate as well.

This is probably Bernanke’s greatest fear and is likely the main reason he waited so long before mentioning the dollar.  The fact that he felt compelled to do so now likely means he knows the game is coming to an end.

Got gold?

[Editor's Note: Global investing guru Peter D. Schiff last wrote about gold for Money Morning. For a more-detailed analysis of the nation's financial problems, and the inherent dangers that these problems pose for both the U.S. economy and for dollar-denominated investments, download Peter Schiff's new financial-research report: "The Collapsing Dollar: The Powerful Case for Investing in Foreign Securities." That report is free of charge. Check out Money Morning's latest report on gold investments, published Friday as part of our ongoing "Cashing in on Commodities" series. That report - "Is Gold Headed for $1,500 an Ounce?" - also is free of charge.]

News and Related Story Links:

• Money Morning Financial Commentary:
  That Pain You Feel at the Pump is From a Dollar Crisis, Not an Oil Crisis.

• Euro Pacific Capital Inc. Special Research Report:
  The Collapsing Dollar: The Powerful Case for Investing in Foreign Securities.

• Money Morning Financial Commentary:
  A Currency Conundrum: Beware of the U.S. Dollar’s “Head Fake” Rally.

• MarketWatch.com:
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• Money Morning Financial Commentary:
  Be Bold, Buy Gold.

• Money Morning Financial Commentary:
  Dallas Fed President Lends Credibility to Money Morning’s Prediction That the Federal Reserve Will Soon be Boosting Interest Rates.

• Wikipedia:
  The Emperor’s New Clothes.

• Money Morning Commodities Investing Series:
  Cashing in on Commodities: Will Gold Hit $1,500 an Ounce?

By Jennifer Yousfi
Managing Editor

U.S. Federal Reserve Chairman Ben S. Bernanke came out in support of a stronger U.S. dollar yesterday (Tuesday), indicating the Fed would remain on pause at its next meeting.

Speaking via satellite at the International Monetary Conference in Barcelona, Spain, Bernanke said the Fed is working with the Treasury to “carefully monitor developments in foreign exchange markets.” The Fed Chair said he was aware the effect of the dollar’s decline on inflation and price expectations, Bloomberg News reported.

Also, interest rates are currently “well positioned” to promote both growth and stable prices, he added.

“I can’t recall such a strong defense of the dollar from a Fed chairman,” Sophia Drossos, a currency strategist at Morgan Stanley (MS) who used to work at the New York Fed, where she helped manage the central bank’s foreign-exchange holdings, told Bloomberg. “The Fed is putting its marker down in letting the market know that a weaker dollar would be detrimental.”

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Ordinarily, the state of the greenback would fall under the Treasury’s watchful eye, but Bernanke’s comments show the Fed chief is aware of the effect the aggressive rate-slashing campaign of the past several months has had on global currencies. The dollar has dropped 16% against the euro, driving up the cost of dollar-denominated commodities such as oil.

“The challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation,” Bernanke said.

He went on to acknowledge the Fed’s commitment to “ensuring that the dollar remains a strong and stable currency.”

The comments from the Fed chairman gave an immediate boost to the dollar, as it climbed to $1.547 against the euro and commanded 104.9 against the yen at the New York close.

Analysts, as well as Fed futures, are pointing to a Fed on pause at the June meeting of the Federal Open Market Committee (FOMC). It is expected the FOMC will vote to hold rates steady, especially in light of the minutes of the April meeting, which revealed the last vote to reduce the Fed Funds rate 25 basis points was a close call for many.

At least one Fed member has gone on record as being against further cuts. Dallas Fed President Richard W. Fisher is the only FOMC policymaker to “dissent” three times on prior votes to lower the central bank’s key interest rate. Fisher has gone so far as to suggest holding rates steady may not be enough to fight current price pressures.

“If inflationary developments and, more important, inflation expectations continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic” U.S. economy, Fisher said during a speech in San Francisco last week.

News and Related Story Links:

• Bloomberg News:
  Bernanke Says Rate ‘Well Positioned,’ Watching Dollar

• Forbes:
  Bernanke Backs The Buck

• The Washington Post:
  Fed Unlikely to Change Interest Rates, Bernanke Says

• Federal Reserve Web Site:
  Chairman Ben S. Bernanke: Remarks on the economic outlook

• Money Morning:
  Dallas Fed President Lends Credibility to Money Morning’s Prediction That the Federal Reserve Will Soon be Boosting Interest Rates

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

There’s one thing you can almost always count on with the government: Coming late to the party.

The release of the U.S. Federal Reserve’s minutes from the April 29 and 30 meeting of the Federal Open Market Committee (FOMC) included several “pronouncements,” none of which you’re hearing from the mainstream press and all of which we here at Money Morning told you were coming months ago.

Four things to think about:

1. The Fed’s doom and gloom forecast of 0.3% to 1.2% gross domestic product (GDP) growth represent the FOMC’s views from over a month ago. Since then, we’ve had a meager round of data showing that a recovery may be building and that there is, in fact, growth. First-quarter GDP was revised upward to 0.9%. And while that might not be as high as some would like to see, it’s still growth… and right on schedule for a possible late-2008/early-2009 pickup.

2. Investors who are looking to the Fed for guidance are driving with their rearview mirrors. The Fed’s data is almost always delayed more than the markets, which means that the smart money has most decidedly and almost certainly priced in the Fed’s “news” months ago. Smart investors have already been taking positions. In fact, that’s what they have been doing since the March 17 lows. They’re also waiting with baited breath for further deterioration in the Fed’s next comments as a result of higher oil prices in recent days… so they can buy in at even better levels.

3. All inflationary measures are rising and have been for over a year now… despite the fact that the Fed has apparently only just recently noticed inflation is rising faster than it would like. And it explains why commodities, some consumer durables and other traditional hiding places continue to defy all odds and rise despite record high valuations like oil, for example.

4. The Fed isn’t running the show and never has, despite what the media and most people seem to think. And “nowhere,” as legendary investor Jim Rogers pointed out when I talked with him recently at his home in Singapore, “does the Federal Reserve Act say the Fed is supposed to bailout Wall Street.” Which means that uninformed investors may be reading something into the Fed’s actions that the Fed itself isn’t charged with.

Federal Defense

Now here’s what to do:

First, when the markets get sideways and uncertain, it’s important to realize that having the proper portfolio structure will save the day – regardless of who’s at the helm (big money) and who might think he’s at the helm (Fed Chairman Ben S. Bernanke),

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And by “structure,” we don’t mean individual stocks or allocation. Instead, what you need is an assemblage of stocks concentrated on the trends of the time, such as energy and inflation, for example.

Traditional diversification, while better than nothing, is just a proxy for having no clue about how to select smart investments. It’s like rearranging the deck chairs on the Titanic. It might look pretty, but it doesn’t work when the entire market goes down at once, as so many investors found out between 2000 and 2002 and again recently.

Structure, on the other hand, is a deliberate attempt to manage risk. That’s why famous investors like Berkshire Hathaway Inc. (BRK.A, BRK.B) Chairman Warren Buffett, George Soros, John Templeton and Jim Rogers concentrate their risks, rather than just spread their money around willy-nilly. [Editor's note: Click here to find out how you can obtain a free copy of Jim Rogers' new best seller, "A Bull in China."]

Not only do certain sectors bounce faster but they also fall less. And those same sectors can kick off huge income as they go, which means that investors who “buy” into this argument are ahead of the game far sooner than those who don’t.

Second, pay particular attention to unstoppable global trends. Then place money squarely in front of where they meet. This is not rocket science. For instance, the world’s electrical systems are antiquated or nonexistent, which means they need to be updated and simply built in the first place to meet demand. Which is why there’s an estimated $16 trillion behind the trend.

Other “unstoppable trends” include the emergence of China, inflation, energy, and even war, which, in a sad testimony to our times, is a growth industry.

Third, think like a plumber. A little water in the wrong part of your house can do a lot of damage, so it’s important not to let it get out of control in the first place. We’re not referring to micromanaging a longer-term portfolio here, but unless you’re a day trader or even a swing trader, there’s no reason to be constantly tweaking your portfolio in search of smaller profits when it’s the bigger picture that matters.

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