One potential trouble-maker to watch out for in 2007

January 3rd, 2007

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As 2006 closed with stock markets around the world in record high with an eerie calm in terms of volatility, it is very tempting to assume that 2007 will bring more of the same. From the news report, many fund managers have such optimistic view. With the supply of money and credit still expanding, it is indeed very much possible for the good times to continue in 2007. But this does not mean there are no dangers. Hence, today, we will look at a possible danger scenario: the sustained downtrend of the US dollar. As we said in Will the US dollar collapse?, it is only a matter of time before this scenario will happen. The question is, will it happen in 2007?

At this point in time, both the US bond and stock market (especially the bond market) are expecting interest rates to decline in 2007. We said before in Are you prepared for the coming storm?, the ?market seems to be spell-bound by some kind perfect wonderland myth?it ?thinks? that the economy is so weak that the Federal Reserve will cut interest rates next year (which is good for stock prices) and so strong that a recession will be avoided.? If events turn out to contradict the markets? expectation, we can be sure that the results will be very unfavourable.

As we elaborated in What can we expect in a US dollar decline?, a sustained decline in the US dollar will show up as inflation in the US domestic front, which will force the Federal Reserve to raise interest rates. With the US economy already faltering, this will lead to a recession. When that happens, the bull run of 2006 will turn into a bear, as it happened before in May 2006 when talk of raising interest rates spooked the stock and commodity markets. Thus, we will be faced with a hard-landing scenario of declining US dollar and rising interest rates. At this point in time, it will be much harder to foresee what will happen next. As such, what follow will be merely our gloomy guesses.

It is possible for a sustained decline of the US dollar to descend into a nightmare rout in the US dollar through a circuitous route of cause and effects (though it is unclear how likely it would be). If that happens, the results will be unpredictably ugly. Though Asian and Middle-Eastern central bankers certainly have the means to set off a disorderly collapse of the US dollar (see Awash with cash?what to do with it?), it is unlikely that they will have the motivation to do so unless some unpredictably drastic developments took place in their domestic front. It is more likely that they will not sell their US dollar reserves out of their own accord?that is, if they should do so, it would likely be because the US dollar is already falling. But whatever the initial cause, if should we see foreign central bankers dumping their US dollars, it will be the sign of the beginning of great global upheaval as there will be great implications on the Middle East and oil (we will talk about that in the future). Since much of the world?s financial assets are denominated in US dollars, there will be a rush to shift from those assets into safe havens?that can only mean old trusty gold, which is humanity?s choice since ancient history.

So, for 2007, watch out for the US dollar!


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