Checkmate for the Fed?

For the first time since the 1970s, the United States is facing the potential of a serious banking crisis and a serious currency crisis at the same time.

So it appears that the stopped-clock permabears may be right, at least for the time being. Let me explain . . .

The Fed's customary solution to financial problems has, of course, been to pump money into the financial system when it is under strain. This strategy worked OK in 1987, after the Asian Crisis (despite creating the tech bubble), after the tech crash (despite creating the housing bubble and the current credit bubble), and during the first phase of the subprime crisis. Bears have each time proclaimed each crisis to be the end of the world, and their fears have always been overblown. And of course, the world won't end this time either.

But I believe that the current situation differs slightly from previous crises, for a single reason: today's Fed faces much steeper consequences for resorting to its favorite solution of credit injection.

Today's dollar market has stopped shrugging off injections of credit. Worried about the decline in the dollar, people now appear to believe that rate cuts and other forms of liquidity injection and preservation plans (the super-SIV plan) place enormous further downward pressure on the dollar. The Chinese, in particular, are reacting to worries about the weak dollar by dumping it and threatening to dump more, which is what most people paying attention have expected to happen for several years.

In many ways what we have is a financial crisis that is based in a crisis of belief. People around the world have stopped giving the dollar the benefit of the doubt simply because it is the dollar.

Notice how the gold ETF has continued to rise after the September surprise half-point rate cut, even while the bank index appears to have received little benefit from these cuts . . .



(Yahoo! Finance)

What does this mean? It means that the Fed's primary weapon of liquidity/credit injection has begun to backfire.

Further injections of liquidity, surprise or otherwise, will almost certainly endanger the dollar, to the point of sparking a free-for-all to escape from it among foreign holders. The Fed, in short, appears to be checkmated.

You have to make your own judgment about how you want to be positioned here, but I am currently positioned very short the money center banks via the Financial Select Sector SPDR (AMEX:XLF) and long gold (via GLD).

If the Fed chooses to try another bailout (the most likely development given its previous behavior), the run on the dollar could turn into a rout, driving gold past $1000/oz. If the last cuts are any indication, further bailouts shouldn't provide a great boost to the banks.

If the Fed opts not to bail out the banks, XLF will really be in for it, and gold should not suffer.

However, a dollar rally (way overdue) will decimate my gold position, so I will be very wary.

Additionally, my current sense from looking at the price action is that the "Smartest Guys in the Room" at the banks are trying desperately to get out of these stocks before everyone else realizes how bad the crisis really is.

Please remember that these are my opinions, and you must formulate your own investment strategies.

The Fed is full of smart people, and it will be quite interesting to see how and if they can escape from this pickle . . .