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     Mar 3, 2006
Bernanke's yield curve fallacy
By Axel Merk

The new US Federal Reserve chairman, Ben Bernanke, believes that the current yield-curve inversion does not signal an economic slowdown.

Yield-curve inversions occur when short-term interest rates exceed long-term rates. Bernanke has argued that when this occurred in the past, short-term real interest rates were high. To



put it another way, he says the Fed is merely in neutral territory and has not yet applied the brakes to the economy. Long-term interest rates are low because of a global "savings glut", because much of the rest of the world would rather put their money into liquid US assets than invest it in other economies with underdeveloped financial markets.

We agree with Bernanke that real interest rates continue to be low; indeed, one of the reasons gold has performed so well is that the Fed has allowed inflation to creep through the production pipeline, even if "core inflation" has not yet reached the consumer.

Bernanke also has a point that there is simply a lot of cash out in the markets that has not been invested. Partially this is because of the Fed's own policies, which have created a sea of liquidity. Another contributing factor has been many Asian economies creating their own bubbles by subsidizing growth with fixed exchange rates. The very high savings rate of China, often reported to be 30-40% of disposable income, is partially due to a lack of attractive investment alternatives. The Chinese stock market, for example, has not been able to attract Chinese retail investors in recent years.

But in our assessment, Bernanke is wrong. An inverted yield curve likely signals an economic slowdown, just as it has many times before. The US consumer is far more interest-rate sensitive than in the past, and consumer spending plays an ever greater role in economic growth; it is now about 70% of gross domestic product (GDP). Although Americans have been known as the world's greatest consumers for some time, never before have consumers bought so many goods on credit. The Federal Reserve had to redefine how it measures household-debt-service payments in 2003 because consumers have come up with ever more creative ways to buy not only homes and cars, but just about everything on credit. If you have watched US television advertisements recently, you may have noticed that we have entered yet another phase as automotive (and many other) ads only state the monthly installment; with most ads, one can no longer even infer the full cost of the car, nor the terms of the lease.

Over the past couple of years, consumers have financed their spending by extracting equity out of their homes and by adding to their credit card debt. Real wage growth has been stagnant. High energy prices have thrown the US savings rate into negative territory. Globalization has kept a lid on wage growth as US companies have been forced to accelerate their outsourcing to compete in an environment with high raw-material prices and little pricing power.

Adding these factors together, we have a highly interest-rate-sensitive consumer. As interest rates creep up, spending must slow down sooner rather than later, unless real wages or asset prices rise. Bernanke acknowledges that the housing market will slow; extracting equity from homes through ever higher mortgages is coming to an end. Bernanke may hope that corporate America will put its massive cash buildup to use, but we believe this US "savings glut" is due to the fact that US corporations see a fragile US consumer and better investment opportunities overseas. In our assessment, the US economy is too dependent on the consumer these days; other sectors of the economy will not make up for a slowdown.

US consumer spending has not declined in more than a decade. The consumer was enticed to continue spending as the tech bubble burst - and after September 11, 2001 - through low interest rates, low taxes and cheap imports. We are now faced with an exhausted consumer who required "employee discounts" last summer to buy cars; who was lured to the stores the day after the Thanksgiving holiday in late November with unprecedented discount offers; and who is being offered a "US$100,000 discount" when buying a new home (Centex, one of the United States' largest home builders, recently had a nationwide "special offer" on what we interpreted to be the bursting of the real-estate bubble in real time).

It is our view that an inverted yield curve does indeed signal a slowing economy. We are afraid, however, that even as the Fed is likely to raise rates further, it will not forestall inflationary pressures. We are rather concerned that foreigners may be less inclined to finance the massive US current-account deficit as the economy slows. In this environment, gold may continue to do well, and the dollar may continue to be under pressure.

Axel Merk is the portfolio manager of the Merk Hard Currency Fund, 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 US dollar relative to other currencies.

(Copyright 2006 Merk Hard Currency Fund. Used by permission.)


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