Iceberg Ahead: Fate of the U.S. Dollar Titanic Sealed by Last Week's Budget Deal

Includes: GLD, OIL, SLV
by: Perry D.

Republicans in Washington claim they're "winning" in the aftermath of spending cuts they reportedly secured in last week's, last-minute budget deal, but those claims are as laughable and contemptible as Charlie Sheen's on his torpedoed "Torpedo of Truth" Tour. Earth to DC: you're headed for a 50-square-mile iceberg, and you've just turned the wheel an inch... probably less.

The $38 billion in cuts represent less than the $54 billion in new debt the U.S. racked up in just the previous week, less than 3% of this year's projected deficit and less than 1% of what the government has projected to spend in 2011. These "cuts" (up to three-quarters of which may be "smoke and mirrors" accounting gimmicks, according to reports looking at the details) have yet to be endorsed by vote, amid grumbling from Tea-Party-linked conservatives in the House.

This hollow drama in DC capped a week in which markets continued to abandon the dollar, with the Aussie and Canadian dollars and the Swiss Franc hitting new 52-week highs, gold hitting record highs, the CRB commodity index hitting 2 1/2 year highs, and crude hitting 30-month highs.

This bookends a 12-month period in which:

1) The dollar has virtually lost safe-haven status: multiple crises (from Japan's tsunami to Middle East turmoil) have been accompanied by ominous dollar dumping rather than the kind of crisis-driven dollar-buying we used to see in the past;

2) Zero Hedge reported over the weekend that bond fund giant PIMCO has gone beyond slashing Treasury holdings and is now actively shorting U.S. debt;

3) The Federal Reserve has become the marginal buyer of most Treasuries offered in auctions over the past year in the growing absence of private-sector or foreign government buyers;

4) Skepticism of the Fed's inflation-fighting credibility is mounting. A new Rasmussen Reports national telephone survey found 56% of adults were very concerned about the threat of inflation, up from 52% a month ago and 48% at the start. Just 14% are not very or not at all concerned. Only 30% were at least somewhat confident in the Federal Reserve Board’s ability to keep inflation under control

I wrote back in January of the growing risk to the inflation outlook and the dollar's purchasing power:

With America's (real) unemployment rate likely to stay in double-digits for some time, a bigger permanent American underclass in the making, economic growth poky and government-inflated at best, no clear signs over the horizon of any significant commitment to improve America's growth the old fashioned way (earn it by improving the business climate), D.C. more widely derided than it's been in decades, and an historically debt-heavy government that will be under ever more pressure to inflate its financial problems away, the Federal Reserve is and will be under the gun in a way it hasn't been since Paul Volcker headed the Fed through the energy crisis of the late 70's and early 80's.

Actually -- the risk is greater today. Paul Volcker had the absolute backing of then-President Ronald Reagan to do what it took to keep inflation under control (including jacking up interest rates into the double digits). Also, the U.S. was in a better financial position (a debt-to-GDP ratio of 30% versus today's roughly 100%). Volcker had bigger pro-votes in the Senate than Bernanke appears likely to get. President Obama's current support notwithstanding, Bernanke can't count on that support tomorrow when political push comes to shove. President Obama no longer has Reagan-sized level of popularity, and the President's party -- predisposed to putting short-term growth ahead of inflation control and long-term stability during the best of times -- can be expected to put more pressure on the Fed to be more loose than it would otherwise be, especially as the 2010 and 2012 elections approach.

In the meantime, amid growing market skepticism over America's economic management, the federal government's plan remains: Spend and print as much money as possible until we can't.

"Both sides are now claiming victory [in the budget battle], that the new (budget) compromise demonstrates the resolve of our leaders to make the necessary cuts so that America can live within its means," said economist Peter Schiff in a recent video. "The reality is, this compromise proves the exact opposite: that there is no will to do anything... that nobody is willing to make any of the cuts necessary to rein in the excesses in Washington."

The fall of the dollar as a reserve currency is well underway-- absent the sudden emergence of policymakers empowered to right the course of the U.S. Dollar's Titanic-- the way the Chilean "Chicago Boys" did for Chile through the 1970's, resulting in its standing today as the most prosperous economy per-capita and the most financially stable and credit-worthy government in Latin America.

Keep an eye on upcoming events, which are likely to be inflection points that further reinforce expectations that the U.S. is headed for self-inflicted disaster:

  • the upcoming debate over raising the debt ceiling: look for a compromise that raises the ceiling without a rock-solid plan to reduce DC's profligacy
  • GOP and Democratic presidential campaigns: look for mealy-mouthed candidates unwilling to be blunt about the magnitude of the problem or what will be necessary to deal with it, and therefore lacking a strong mandate to course-correct
  • 2012 elections: If the results are viewed as an endorsement of the past 6+ years of big government or even just confirmation of the electorate's unwillingness to accept needed reforms, it's game over.
Use Intrade to track political-event speculation and get confirmation on where we're headed as we approach these points on the timeline, and brace your portfolio for an imminent dollar crisis.

Ignore the commodity "bubble" talk: Back up the truck on gold, silver, oil and other hard commodity assets that will provide protection from further erosion in the U.S. dollar's purchasing power and the American government's current, effective policy of stealth taxation via inflation. Specifically, I'd strongly recommend a diversified basket of related ETFs including GLD, SLV, and OIL. If you prefer less volatility, you should at least have inflation-protected Treasuries (TIPS) in your portfolio, though they're subject to the risk of government undermeasurement of inflation, as they're tied to the Consumer Price Index.

Again, I'd use the timeline points above as confirmation signals to increase such inflation protection.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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