Will Bernanke Save the Dollar?

Axel Merk, June 15th 2006 --

Recent hawkish comments by Federal Reserve (Fed) Chairman Ben Bernanke
caused jitters in US and global equity markets; as is the typical first
reaction when there is a sense of panic in the market, US investors
liquidated some of their more speculative foreign investments and
repatriated the money. As a result, the dollar enjoyed an overdue rally
after it had been sliding for weeks versus major currencies. Did
Bernanke ring in a new era at the Fed? Will he be able to help contain
inflationary pressures? And will the dollar regain its strength?

When we recently analyzed whether nominated Treasury Secretary Paulson
could save the dollar, we pointed to the fact that policies reining in
domestic consumption would reduce the current account deficit, and as a
result alleviate some pressure on the dollar. Politicians rarely call
for a drop in consumer spending; this unpopular task is traditionally
left to the Fed. The Fed controls money supply and interest rates; and
while the Fed has continued to boost money supply, higher interest
rates are starting to take their toll on the consumer. Does that mean a
slowing US economy translates into a higher dollar? Not quite...

Bernanke spooked the markets by daring to say what has been ignored for
too long: inflation is heading our way. We already experience inflation
on anything we cannot import from Asia - from the cost of healthcare
and education to the cost of local services. Low interest and tax rates
in the US, combined with Asia's growth policies have created an
oversupply of goods has lead to low consumer goods and high commodity
prices. Corporate America has up till recently been faced with little
pricing power because consumers neither needed to pay more for goods
(cheap imports), nor could they afford to (high debt); to maintain
margins, outsourcing was accelerated, keeping a lid of job and wage
growth. Slowly, but surely, however, inflation has been creeping
through the production pipeline. Gradually, wage pressure is
increasing; corporations are finding ways to pass on higher prices; and
finally, some of these pressures appear in government statistics.

Bernanke has a problem, a big problem: inflation is creeping up just as
the economy is slowing down. Some have pointed out that it is quite
common for inflation to continue to climb for a couple of months as the
economy is slowing down; as a result, we should not be concerned about
it. These are the same 'experts' that only saw the internet bubble
out of the rear view mirror and are still do not acknowledge there is a
housing bubble. What many underestimate are the extremes we face:

Inflationary pressures have been ignored for a very long time because
they did not make it through to the government's "core inflation"
statistics. The Fed relied on globalization to contain inflation.
The consumer is far more interest rate sensitive than ever before. Just
about everything is bought on credit now. Bernanke's predecessor
Greenspan loved this "efficient" consumer. The problem is that this
efficient consumer has to cut back much more sharply when faced with
higher interest rates (or shocks, such as losing a job).
As interest rates edge up, the economy will slow down sooner than it
would if the consumer was not as interest rate sensitive. This is
exacerbated as consumers can no longer extract additional equity out of
their homes. We do not need falling housing prices to harm consumer
spending - stagnant prices are harmful enough. Anecdotal evidence
also suggests appraisers are under a lot of pressure to keep up the
values of homes to allow those who want to refinance to lock in still
low long-term rates. All those who have taken out 100% mortgages while
locking in only 1, 2 or 3 years will learn that they can only refinance
if their property is assessed to be worth at least as much as their
homes.

Indeed, in the comments that rocked the markets, Bernanke not only
talked about rising inflationary pressures, but also about a pending a
slowdown in consumer spending. These are problems that require
diametrically opposed Fed policies. If the Fed is to fight inflation
thoroughly, it will - in our assessment - cause a very severe
recession, if not depression; and if the Fed was to ease, inflation is
going to be a very serious issue.

So Bernanke does what all central bankers would do in this situation:
talk tough. It's the cheapest of all policies in the arsenal of Fed
tools, and it works - for a while anyway.

What about action? We believe the Fed will raise rates just far enough
to throw the US economy into recession, but not far enough to contain
inflation. The price of gold above 600 dollar an ounce shows that many
are share the view that the Fed will not impose a severe recession onto
the country.

What are the implications for the dollar? While a slowing US economy
may alleviate the current account deficit, it also discourages
investment, in particular foreign investment. Why should foreigners
invest in the US when it is perceived that there are better
opportunities elsewhere? We don't need foreigners to stop investing
in the US, but simply to invest a little less to cause a problem for
the dollar: with a current account deficit in 2005 exceeding $800
billion, foreigners need to invest over $2 billion in US dollar
denominated assets every single day, just to keep the dollar from
falling. Foreigners will need to buy less should there be a domestic
slowdown, but will foreigners be just as willing to finance the trade
and budget deficits?

Going back to what Bernanke may do about the dollar, don't expect
help. First, Bernanke has broken the taboo that the Fed ought not to
talk about the dollar, but leave that up to the Treasury Secretary.
That taboo has been there for a good reason, namely to maintain trust
in a fiat currency not backed by gold, but only the faith in our
politicians. He explicitly discussed the dollar in testimony, and
dedicated a full paragraph to it in the latest Fed minutes. While
sometimes it is unavoidable to talk about the dollar as the Fed
Chairman, he seems to seek the discussion. Bernanke, a self-described
student of the Great Depression, considered the strong dollar an
important reason why the Depression was as long and as severe. Part of
Bernanke's rise to fame as an academic comes from his role as an
advocate of Japan's ultra-loose monetary policy.

All of this leads us to conclude that Bernanke will not come to the
dollar's rescue. With many policy makers favoring a weaker dollar,
and the weight of the current account deficit continuing, we think that
the recent strength in the dollar may be temporary. We have noticed far
broader interest in the dollar's fate - a sign that many are
getting concerned about what it means for their investments. Investors
are realizing that a slowing US economy may be a bad omen for US equity
& real estate markets, as well as for investments in many speculative
places overseas. There is a lot of disagreement about what is going to
happen in the bond markets as it struggles whether to focus on a
slowdown or inflation. As many investors are looking for safety, be
aware that US dollar cash is no longer the safe haven to revert to. In
our view, one has to take a diversified approach even to "safety"
- gold has traditionally fulfilled this role, although gold can be in
itself rather volatile. "Hard assets" traditionally fulfill this
role, although be aware that real estate with its inherent leverage is
unlikely to fulfill this role; it is of no surprise to us that a
Picasso was recently auctioned off for $90 million. One can also
consider taking a diversified approach to cash itself, such as through
the Merk Hard Currency Fund we manage.

We would also like to invite you to a Web conference on Wednesday, June
21, 2006, where we discuss the pressures on the dollar in more detail
(click here to register). 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.merkfund.com.

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

The Fund may be appropriate for you if you are pursuing a long-term
goal with a hard currency component to your portfolio; are willing to
tolerate the risks associated with investments in foreign currencies;
or are looking for a way to potentially mitigate downside risk in or
profit from a secular bear market. For more information on the Fund and
to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges
and expenses of the Merk Hard Currency Fund carefully before investing.
This and other information is in the prospectus, a copy of which may be
obtained by visiting the Fund's website at www.merkfund.com or calling
866-MERK FUND. Please read the prospectus carefully before you invest.

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
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may also invest in derivative securities which can be volatile and
involve various types and degrees of risk. For a more complete
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prospectus.

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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.

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