Dollar strength - a bubble soon to burst

With all this uncertainty in Europe, shouldn't gold and silver be going up?

You might think so.

But with the re-emergence of the Greek problem in the global Mainstream Media (MSM) this month, we have seen a return to the "risk-off" trading sentiment - the purchase of greenbacks at the expense of the metals, as fears of a sovereign default lead traders into a rush for liquidity, resulting in a stronger dollar and weaker gold and silver prices.

This phenomenon occurred regularly towards the end of 2011. Wise investors would do well to bear it in mind - particularly when using leverage to trade the metals.

However, the most important thing is to not lose sight of the fundamentals. Ask yourself, does any short-term upswing in the dollar signal the following:

1. An improved US fiscal outlook?

2. A return to a jobs-led real economic recovery?

3. A genuine increased demand for the dollar on the global stage?

If you believe the answer to any of these questions is yes, I would suggest closing your web browser now as this blog is unlikely to be for you!

Dollar strength is merely a reflection of the Euro's more up-front weakness. Psychological shifts take time and the dollar, for the moment, is still the world's reserve currency - a source of liquidity when faced with shrinking balance sheets and perceived strength.

One way or another, the Euro situation will subside. Greece will either be bailed out to the hilt or allowed to default and leave the Euro. Traders minds will move back to the dollar, as will the attention of the MSM. Such a resolution in the Eurozone will be bullish for the single currency, and by extension, bearish for the greenback.

Of course, there is always the possibility of a trigger event as described many times on this blog before. Such an event could be dramatic enough to turn traders' attention away from a still unresolved Euro crisis to an even bigger US crisis.

Whatever happens, we are headed for an unwinding of the dollar, most likely over the course of 2012. Needless to say, this will result in continued higher prices for gold, silver, the commodities and non-US currencies.

EUR / USD calender - February 2012

Dollar positive or negative? For your consideration.

12 February

EU - Greek parliament to vote on the cuts package needed to secure next EU bailout.

14 February

US - Retail sales numbers, Business Inventories and Import Price index.

15 February

EU - Euro zone finance ministers are due to meet to sign off on the rescue package

US - Fed releases minutes of January policy meeting.

US - More data

- Empire manufacturing numbers
- MBA Mortgage apps
- TIC flows.
- Capacity Utilization.

16 February

US - More data

- Weekly jobs numbers
- PPI
- Housing starts
- Building permits
- Mortgage delinquencies
- Philadelphia Fed index.

17 February

US - More data

- CPI numbers for January
- Leading indicators.

29 February

EU - ECB 3-year bank loans - second installment. Estimated between 400-500 billion euros.

Dollar watch - waiting for Archduke Ferdinand

World War 1 was precipitated by the assassination of Archduke Ferdinand in Sarajevo.

What will be the dollar's Archduke moment?

Five scenarios, foreign and domestic, are considered below.

1. US Treasury bond failure

At the sharp end of this scenario, China could just decide to stop buying US debt. Alternatively, a famed Dutch bond-dealer might decide 'safe-haven' US debt just doesn't look so safe any more, causing a stampede out. At the softer end, the US could experience a general increase in the cost of its borrowing as global investors turn their attention away from the Eurozone and develop a greater awareness of the depth and degree of the US problem. To put it simply, you're looking at the dollar being quickly hanged or slowly choked.

2. Iran

A war between Iran, Israel and the US would by itself cause the value of the USD to further decline. Other implications, however, could be far more severe for the USD:

2.1 The Petro dollar - even with just the US/EU sanctions, Iran is turning to its friends India, China and Russia to shore up its oil exports to maintain its economy. When the deals are done, how likely are they to still be in the USD, the world's reserve currency? Whether they trade in gold or local currency won't matter - demand for the USD will plummet taking with it its artificially propped-up value.

2.2. The US' national debt - the US cannot afford a war. In the event of an all-out military affair, the debt ceiling will have to be raised before November's Presidential election. In this event, President Obama will have to ask Congress for more money. Remember the impact on the USD during last August's debt ceiling debacle? The implications are likely to be only more severe this time around.

2.3 Who would even buy the debt? - even in the event Obama succeeded in raising the debt ceiling, who would continue to buy US Treasuries at current prices? It would astonish me if the cat isn't out of the bag by that stage. The only 'solution' remaining will be for the Federal Reserve to step in, knight in shining armour, to monetise the deficits. Vast amounts of newly created money would almost certainly lead to the rapid onset of hyperinflation.

3. Domestic inflation

Whilst the Fed's balance sheet has increased exponentially since 2008, we have not yet seen super-high price inflation. The reason for this is the velocity of money has remained flat - the rate in which money is circulated in the economy has stagnated or slowed. Scarred by the events of 2008 and the ongoing economic recession, banks aren't lending just as consumers aren't spending. However, with recent economic data showing improvement in the nominal GDP figures, banks and consumers might start to feel confident enough to re-start lending and spending - at least to a critical extent, resulting in noticeably greater numbers being recorded on the Government's core inflation measure.

Such an incidence would obviously have foreign, as well as domestic, implications for dollar holders.

4. Commodities exchange default (COMEX)

Hedge fund manager Eric Sprott reported how long it took for his firm to take delivery of the physical silver he had ordered for their ETF. Furthermore, that the dates inscribed on the bars were post the date of order, pointing to a severe shortage on the inventories. Should there be an actual failure to deliver futures contracts for precious metals, confidence in the whole COMEX exchange will be lost and an already crowded physical market will have to make room for more. The result? Sharp price spikes in the metals and equally sharp price movements to the downside in the dollar.

5. Threat of a banking failure

The Fed is on its guard for any sign of another Lehman moment - this will not be allowed to happen. To avoid another bank going down and systemic collapse the Fed will have no choice to print money like crazy to buy up all the bad assets in sight (yes, 2008 all over again). Such a situation would save the banking system (yes, again) but would be dollar negative and with potentially hyperinflationary consequences.

What do you think will happen?

Over and out.