Bernanke’s Transient Hopes

Axel Merk, July 21st 2006

When Federal Reserve (Fed) Chairman Ben Bernanke was President Bush’s Chief Economic Adviser, he described high oil prices as transitory. Transient they were: they headed higher, not lower. In his testimony before Congress, Bernanke now calls inflationary pressures transitory, predicting they will abate by next year.

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Bernanke’s testimony, for the time being, has raised hopes again of a goldilocks economy. And if the economy does not pan out as predicted, he has already indicated that the turmoil in the Middle East would be at fault.

It has become apparent that the economy is slowing down. Homebuilders have been increasingly reporting challenges; home sales and prices have started to fall. Builders of luxury goods such as yachts have warned that even the so-called high-end consumer is cutting expenditures. Even Target, the mass retailer and catering to more affluent consumers has warned it cannot meet its own targets. The message to the Fed is clear: rates are high enough to induce a recession – raising rates any further will cause serious disruptions.

But it has also been very clear that inflation is rising. The cost of transportation and apparel are amongst the leading culprits in pushing the consumer price index (CPI) higher. And while energy prices even helped to reduce the CPI for this report, oil prices were above $70 a barrel before the most recent escalations in the Middle East. Inflation cannot be switched off like a light switch: while inflation has been held back by globalization, it has not been eliminated. As of a few months ago, the processors of raw materials suddenly have some pricing power, and we would expect inflationary indicators to continue to go up.

It comes as no surprise that Bernanke’s testimony was perceived positively by just about all markets: the stock market, the bond market, the gold market; only the dollar fell.

A few weeks ago, Bernanke rattled the markets with his tough inflationary talk. He was well aware already then that the economy was slowing, but inflationary pressures were building. It was only too clear then already that hawkish talk is about the most he could do, as increasing rates significantly would have been detrimental to the economy.

Now, investors are excited that the Fed seems “done”. Well, the Fed does not have much of a choice – there is simply too much leverage in the economy through consumer debt. “Typically” the economy peaks before inflation peaks; unfortunately, we do not live in typical times. With stimulus after stimulus to keep the American consumer spending, global overproduction has lead to inflationary pressures everywhere. However, even 0% financing offers for 5 years or longer by car manufacturers cannot get consumers go out and buy another car. The consumer is exhausted, needs a recession.

Gold rose on Bernanke’s testimony. The buyers of gold believe we are entering a period of stagflation, and that the Fed will ease before inflation is contained. His testimony confirmed that indeed the economy is more important to the Fed than price stability.

Bernanke will face many more “transient” challenges in the coming months and years. In his verbal testimony, Bernanke seemed less comfortable than in the past. We would not be surprised if the markets will take a less benign interpretation of Bernanke’s testimony once they realize the path we are on. The only area in the economy that seems to be making significant money is the investment banking sector: rather than employing their cash to invest, corporate America is using their cash to engineer mergers, acquisitions and other financial transactions. Corporate America is hesitant to invest their cash domestically as they see the US consumer slowing down and better investment opportunities overseas.

After a significant slide in April and May, the dollar has had some relief. While a drop in consumer spending may help to alleviate the enormous US current account deficit as it increases savings, we are concerned that it will be dwarfed by foreigners’ reluctance to finance the deficit as the US economy slows; foreigners might be tempted to invest their money elsewhere as the US economy slows. We may see the growth in the current account deficit abate just as the dollar resumes its fall.

We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfunds.com.

Axel Merk
Manager of the Merk Hard Currency Fund, http://www.merkfunds.com/

The Merk Hard Currency Fund is a no-load mutual fund that invests in a basket of hard currencies from countries with strong monetary policies assembled to protect against the depreciation of the U.S. dollar relative to other currencies. The Fund may serve as a valuable diversification component as it seeks to protect against a decline in the dollar while potentially mitigating stock market, credit and interest risks—with the ease of investing in a mutual fund.

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The Fund primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Fund owns and the price of the Fund’s shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Fund is subject to interest rate risk which is the risk that debt securities in the Fund’s portfolio will decline in value because of increases in market interest rates. As a non-diversified fund, the Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. The Fund may also invest in derivative securities which can be volatile and involve various types and degrees of risk. For a more complete discussion of these and other Fund risks please refer to the Fund’s prospectus.

The views in this article were those of Axel Merk as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice nor considered as an offer to sell or a solicitation of an offer to buy shares of any securities mentioned herein. Mr. Merk is the founder and president of Merk Investments LLC and is the portfolio manager for the Merk Hard Currency Fund. Foreside Fund Services, LLC, distributor.