Bill Fleckenstein: Is the US stumbling into a currency war?

Contrarian Chronicles10/1/2010 5:02 PM ET

Is the US stumbling into a currency war?

The Fed is weighing how to push more money into the economy, and, given the central bank's record, that's bad news for the dollar. Gold, anyone?

By Bill Fleckenstein
MSN Money

As the country's economic and financial woes refuse to recede, the worst-kept secret is that the Federal Reserve is going to engage in another round of quantitative easing, which I have come to refer to as QE2.

What actually is not known is what form said QE2 will take. "Fed mulls new bond approach," a story in the Sept. 28 Wall Street Journal by Fed reporter (and mouthpiece) Jon Hilsenrath, suggested that our central-bank powers that be have not decided exactly how to implement its QE2. According to the article, any Fed action to push money into the economy would likely be on the small side, yet over a longer period, as opposed to a large, short-lived "shock and awe" approach.

This story is something of a wild card, because one could interpret it as forecasting that the Fed will have tighter purse strings than one might have imagined. On the other hand, it portends that whatever "solutions" the Fed comes up with will be more permanent and therefore actually more stimulative in the long term.

Death by a thousand paper cuts

No matter how you look at it, the Fed's track record has proved that the outcome will not be good news for the dollar. At first glance, this might appear to be an issue of concern only to Americans, but the news last week proved otherwise and perhaps a bit more.

Even more important than Hilsenrath's article was an above-the-fold column Sept. 27 in the Financial Times headlined "Brazil in 'currency war' alert," in which Brazil's finance minister declared: "We're in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness."

The article notes that various countries (i.e., Japan, South Korea, Taiwan) had intervened to help weaken their currencies and acknowledges the generalized weakness in the dollar.

The same issue of the FT also covered a large related story, "Hostilities escalate to hidden currency war," so this is a phenomenon I suspect we will hear more about.

What quaintly was referred to in the old days as beggar-thy-neighbor policies of debasing one's currency to benefit exports is certainly under way, and it will be illuminating to see what occurs on this subject at the Group of 20 global finance meeting in November. My expectation would be that this will be problematic and that it will be difficult for the attendees to put a smiley face on it. (Got gold?)

London calling

While all the talk of QE2 and currency issues might have been expected to prove beneficial to precious metals, their reaction to these articles was initially to yawn (actually, sink). However, something occurred in the gold futures market last Tuesday that is definitely worth noting.

A very well-connected friend of mine (and longtime commodity trader) called me that morning to point out that an unusually large trade had taken place very early in London to the tune of more than 8,600 futures contracts. As he noted, this was approximately a $1.1 billion sale, but, significantly, it didn't really cause the price of gold to fall much (as it would have in the past). In fact, by the day's end, gold had recovered all of that morning's losses and gained 1%.

My friend brought this to my attention because the current sentiment seems to be that the gold market is crowded and that the first time a big seller appeared, the price of gold could be expected to drop $25 or $30 immediately and then go into an even bigger slide. Thus the fact that this huge trade could be absorbed so easily was an indication that the gold market was potentially deeper than a lot of people had thought (my friend included).

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These conclusions are all sort of theoretical, but so is the thought that the gold market is crowded. Nonetheless, if a trade that size was on the up-and-up and not some completely coincidental bit of noise (which would be hard to imagine), it is bullish in the sense that it does show increased market "depth" in gold, contrary to what used to be the norm.

This development would be a big plus in attracting very large investors who may have been worried that the gold market was too thin (i.e., that it lacked the liquidity necessary) for them to get involved.

On the air

Finally, last week I participated in a wide-ranging discussion of macro-economic topics in my continuing series of interviews with Eric King. Interested readers can listen to it here.

At the time of publication, Bill Fleckenstein owned gold.

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