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By: Chris Rowe — November 30, 2010

Ben Bernanke - "I've GOT This"

Maybe the Fed actually knows what it's doing. 

With all that we are seeing coming from Wikileaks, it's a stark reminder that what's in the public eye isn't necessarily the whole story.  (Duh!)

Is it possible that the Fed's analysis of this situation is a bit better than we think?  Woah!!  Calm down everyone!  I can already see a crowd with torches forming outside my window.  It's just a question, not a statement. 

The question is:  Is the Fed willing to tear down a house that was built over the last century?

A lot has changed over the last century, hasn't it?

The United States of America emerged from World War I as a creditor as opposed to a debtor nation.  We had a record trade surplus.  Wall Street then assumed leadership as the investment capital of the world, taking the crown from London.

Today, China and Japan alone own $1.7 trillion in US treasuries.  No more trade surplus. 

The Federal Reserve system has also certainly changed roles, hasn't it?

In 1913 the Federal Reserve system was established to "control credit and bring greater stability to the banking structure".  Today, they find themselves manipulating equity markets through permanent open market operations (paying off the primary brokers/banks to push stocks higher or knock them down) and attempting to "stimulate" the housing market.

But purchasing mortgage-backed securities (previously referred to as toxic assets) and printing money to spend enough on treasuries to keep interest rates down are not the only ways the Fed is attempting to stimulate housing prices.

You see, over the long haul, the dramatic inflation that should inevitably result from all of this greenback printing will cause the US dollar to be worth much less. 

What does that mean?

Well, during inflationary times, housing prices rise.  Or at least it seems that way.  It might cost you more dollar bills to buy a single-family home ... but it might not cost you more in terms of copper, gold, silver, corn, potash or soy.  While the amount of home you can get might decrease in terms of dollar bills (home prices rising), you may see similar buying power of a home in terms of commodities as currency.

It might seem to the layperson like prices are rising.  And they will be.  But home values might be a different story. 

Perhaps home prices will rise faster than commodity prices, which is doubtful.  But either way, real estate investments will probably be a great way to protect yourself from inflation down the road. 

Also, what will inflation do to the value of our debt?  Well, obviously we won't be paying China and Japan back in corn, will we?  I'm sure they would probably prefer that we did.  But the legal agreement for our treasuries is that the United States returns the number of dollars that it borrowed, which will be worth a lot less.

It makes you wonder what the real agenda is of the Federal Reserve.

But for the time being, it's not the United States' economic disaster that is in focus.  It's the European economy that people are extremely concerned about.

If you compare a chart of the euro to that of the S&P 500, you'll see a bit of a correlation because the euro tends to have an inverse relationship to the US dollar index, and so does the S&P 500.

So when you are reading about yields on Spanish bonds jumping, or Ireland bailouts from the IMF and the EU, or troubles brewing in the euro-zone, and you're trying to make sense of it and wondering how it affects the United States stock market, it's pretty simple and it boils down to one thing: When investors are afraid of the euro zone, they exit the euro as the currency, which pushes the US dollar index higher, which in turn puts downward pressure on the US stock market.

At the same time, while investors are exiting the euro (an action which, by itself, pushes the dollar higher), they are also looking to store that value somewhere, and therefore they often exchange it for US currency.

40% of the earnings in the S&P 500 come from overseas.  Basically, when overseas markets get hit, it also hurts the large U.S. companies.  So while the longer-term agenda of the Federal Reserve will probably smash the US dollar, pushing it lower, resulting in higher home prices, higher stock prices, and much higher commodity prices, the intermediate term trend for the US dollar is up. 

But wait!  Everyone's afraid of the Fed knocking the dollar down, aren't they?

The United States emerged from World War I with thriving industries and a huge trade surplus.  At the same time, much of Europe lay in ruins. The British treasury surrendered London's historic role of financing world trade by imposing an informal embargo on foreign loans because of the pound sterling's postwar weakness.  The United States, for the past century, has played the historical role of financing and world trade. 

My question to you is this:  Do you believe that the Federal Reserve of today is looking to single-handedly destroy this empire just to manipulate currencies and assets, or do you think the Federal Reserve believes it's making a bet that the US dollar has enough relative strength, when compared to global currency, to satisfactorily maintain value even after the Federal Reserve buys another $600 million - $3 trillion in treasuries?

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