True Conspiracy

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Friday, July 21, 2006

Federal Reserve Does Not Fight Inflation, It CAUSES It.

We are now living in an inflationary war cycle. Over the coming decade, I expect massive inflation (money-supply growth) and worsening geo-political conflicts. During such a hostile environment, commodities (especially gold and silver) are likely to outperform every other asset-class.

At present, there is a lot of noise about a commodities "bubble". The majority of "experts" are convinced that commodity prices have risen too much and they'll collapse. On the other hand, stocks and bonds are being touted as bargains; the foolproof road to riches and financial freedom! These days, the mainstream media is awash with analysts who are claiming that commodities will suffer due to rising interest-rates. Frankly, I find their argument totally absurd.

History has shown that commodity prices are positively correlated to the direction of interest-rates. On the contrary, financial assets such as stocks and bonds are negatively correlated to interest-rates!

I'll let you in on a secret, which is essential to your success as an investor. You must understand that the central banks don't raise interest-rates to fight inflation. After all, the modern-day central banking system IS inflation! Central banks raise or lower interest-rates in order to manage the public's inflation fears or expectations. During such times when the public wakes up to the inflation problem and starts losing faith in the world's paper currencies (present scenario), central banks raise interest-rates to show that they're fighting inflation. Interest-rates are pulled up in an effort to restore confidence in the world's currencies as a higher yield makes currencies more attractive. On the other hand, when the public's inflation fears are under control and confidence in the monetary system is high, central banks lower interest-rates to create even more inflation!

During cycles of monetary easing, the rate of inflation (money-supply and credit growth) accelerates, thereby creating an economic boom. On the other hand, during periods of monetary tightening (such as now), the rate of inflation (money-supply and credit growth) slows down temporarily, causing financial accidents in a highly leveraged global economy. Make no mistake though, the response or cure offered by the central banks to every financial accident is always more inflation and credit.

At present, every central bank has assumed the role of an "inflation-fighter"! Interest-rates are being increased in the majority of countries under the pretence of controlling inflation. However, it is worth noting that despite rising interest-rates, our world is still awash in liquidity. Recently, the non-gold foreign exchange reserves held by the central banks rose to a record US$4.4 trillion, up nearly 10% year-on-year! Emerging nations held a record US$3.07 trillion and the developed nations held a near-record US$1.33 trillion.

Opinion is divided as to whether interest-rates will continue to rise. The majority seem to think that the Federal Reserve won't raise interest-rates much further for the fear of seriously hurting the housing boom. However, I feel that the US interest-rates will have to continue to rise or else the US dollar may stage a dramatic decline. Given a choice between protecting either the housing boom or an outright collapse in the US dollar, I can assure you that the Federal Reserve will choose the latter. The truth is that the Federal Reserve exports US dollars to the entire world and it'll do everything in its power to delay the destruction of its merchandise. In summary, I concede that the Federal Reserve may pause during the second half of this year to offer some respite before the US mid-term election in November. However, the major trend is now up and interest-rates may well be in double-digits within 5 years.

If my above assessment is correct, you can bet your bottom dollar that stocks, bonds and property are going to come under serious pressure. Already, the real-estate market in the US is showing signs of a slowdown as the establishment tries to engineer a soft landing. In my opinion, we now amidst a global housing bubble, which will eventually deflate due to rising borrowing costs. Figure 2 shows the US 10-year Treasury Yield, which determines the mortgage rate. As you can see, bond yields fell between 1981 and 2003. As the cost of borrowing declined, housing as well as bond prices went through the roof! However, in June 2003, bond-yields bottomed out and have been rising ever since. Over the past 3 years, the cost of borrowing has become more expensive and we're beginning to see its impact on the slowing real-estate markets worldwide. Figure 2 confirms that the US 10-year Treasury Yield has now broken out of its 20-year downtrend (red arrow) and this is an ominous development. This breakout points to much higher interest-rates in the future so I'd have to advise you to sell your leveraged properties and bonds without further delay. The great bull-market in bonds ended in June 2003 and this is not a good time to be invested in fixed-income assets.

In the past, I've stated that in a highly inflationary environment, stocks, commodities and real-estate can all rise at the same time. Basically, an over-supply of paper money causes its purchasing power to diminish. I still maintain that over the coming decade, even if all assets (with the exception of bonds) continue to rise, I expect commodities to outperform all other asset-classes on a relative basis.

Puru Saxena

Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication NOW available at

An investment adviser based in Hong Kong, he is a regular guest on CNBC, BBC World, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes for several newspapers and financial journals.

Copyright © 2006 Puru Saxena Limited. All rights reserved

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