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Financial Heroin
New York: April 11, 2011
By John Stephenson

The U.S. dollar hit a fresh 15-month low last week, as traders reasoned that Ben Bernanke\'s experiment with financial heroin would continue and the European Central Bank raised interest rates a quarter point. This combination sent the dollar index, which tracks the U.S. greenback against a basket of peer currencies, tumbling to 74.88, a level not seen since December, 2009. Commodities are typically priced in dollars so a weaker dollar helps boost raw materials prices. Monetary alternatives such as gold and silver were on fire last week, with gold reaching an all-time high of $1,475 per ounce and silver punched through $40 per ounce. Tin hit a record $33,000 a ton and copper is back up at $4.50 per pound as traders bet that real things were going to outperform paper currencies at least in the short run.

Helping to spur precious metals prices higher is strong investor interest from retail buyers for precious metals coins. The United States Mint recently discontinued the minting of the 2010 American Eagle One-Half Ounce Gold Proof Coin and the 2010 American Eagle One Ounce Silver Proof Coin in response to sharp investor demand. And for some Americans, their faith in the greenback has been severely tested. Last month the Utah state legislature passed a bill allowing the use of U.S. gold and silver coins as legal tender and many other U.S. states are considering similar legislation.

Many analysts and investors now see $1,500 gold and $50 silver as the next most likely milestones for these two precious metals to hit in coming months, as a “looser for longer” monetary policy weighs on the U.S. dollar. Some investors are even reckoning that the Federal Reserve will need to embark on a third round of quantitative easing or QE3, a move that would help accelerate the stampede into precious metals and commodities generally. And silver, like gold, has been used as currency with the U.S. on a silver standard before it was on a gold standard. In fact, the Coinage Act of 1792 established “that the proportional value of gold to silver…shall be fifteen to one” under a policy of bimetallism.

Investors have flocked to gold and silver coins and bars as it has become clear to them that their savings accounts are paying nothing and that central banks are hell bent on debasing their currencies by flooding the system with worthless paper money. With the Federal Reserve expanding its balance sheet at the fastest pace in history, and sovereign risks replacing corporate risk as the new benchmark for junk bonds, their concerns seem justified. And nothing offers better protection for investors than precious metals for the twin worries that are overhanging the market—inflation and financial catastrophe.

To date, the Federal Reserve has argued forcefully that deflation, or falling prices, rather than inflation is the real worry. This argument helped the Fed justify that massive amounts of money needed to be pumped into the American economy in an attempt to reflate the sagging economy and the stock market. But with commodity prices surging across the board, this argument appears to be full of holes.

While precious metals prices are the canary in the coal mine of monetary debasement, the Fed\\\'s deflation argument was dealt a serious blow by the rise in oil prices. With food and fuel prices on the rise, it can no longer be argued that accommodative monetary stance is in the best interests of the economy or consumers. And while in the past, the surging prices for food have been blamed on whacky weather and poor harvest rather than as a signal that inflation was surging out of control, the soaring prices of all commodities is offering pervasive proof that inflation, rather than deflation, is the order of the day.

With corn at $7.67 per bushel, oil at $113.15 per barrel and cotton at $2.12 per pound, it costs more to eat, drive and clothe yourself. While the rise in crude oil was once chocked up to a variety of short-term supply interruptions, the reality is that the price level could never have been sustained at north of $100 per barrel if inventories were massive. Lately, there is new evidence emerging that the Saudis may need oil prices in the $85 to $90 per barrel range to support all of their various subsidies and handouts. The prospect of sharply higher oil prices and their effect on the economy is something that central bankers can not ignore indefinitely. And while the cost of iPads and other technologies may be coming down, the price increases that matter to most Americans are heading sharply higher.

The spectre of commodity-driven inflation is leading to the moment of truth for both markets and policy makers. An accommodative monetary policy that is the equivalent of financial heroin has helped spark a sharp rally in stocks and commodities. But the unintended consequence of the system becoming hooked on the heroin of easy money policies is that the withdrawal of this financial heroin will surely be painful. And as any good drug dealer knows, once you get your customers hooked, withdrawal is next to impossible.

And so the stage is set for sharply higher commodities prices in the decade that lies ahead. The Fed can choose to go cold turkey by removing its regular jolts of stimulus from the economy, but that will risk the nascient recovery. And while the S&P500 has enjoyed an impressive rally, once the broader investment market figures out that inflation is a permanent fixture, rather than a temporary one on the investment landscape, then look out as the bloom will be off that rose. Manufacturing and consumer stocks that are sensitive to rising inflation pressures will suffer a big P/E haircut that will last a long time.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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