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Sanders Research Associates

SRA Founder's Comment, May 13 2003

THE WAR ON TERROR REACHES THE FINANCIAL MARKETS

By Chris Sanders
May 13, 2003

The Federal Reserve's May meeting was superbly timed to ramp the US bond market. The huge refunding went without a hitch thanks to the Fed's concern, exquisitely voiced in the official statement, that deflation risks now outweigh inflation risks. It is not clear to us that this particularly impressed the public. The ten-year auction was, by all accounts, sloppy. However, the banks were very large buyers of Treasuries in the two weeks before the FOMC meeting. Not only did the Fed's action ratify the banks' prescience, but it offered them a profitable price at which to unload some of this inventory onto investors.

It seems quite clear that the Fed is moving closer to what it calls "unconventional" measures, ostensibly to offset the risk of a self-reinforcing deflation. There may be Fed governors that really do worry about deflation, but deflation is not the Fed's biggest problem, or even a problem. Financing the growing government deficit is. In declaring its bias toward lower rates and clearly mobilising its principle shareholders, the banks, to buy the bonds that finance it, the Fed is in fact moving closer to a war footing. The US financial system is being mobilised along with its military.

That this is not even discussed in the public media is a triumph of agitprop and expectations management. Investors and citizens should take note, however. The dollar is in free fall; a rout that would have already been disastrous were it not for the heroic efforts of the Japanese Ministry of Finance and the Bank of Japan to support the US currency. No one knows how far the Japanese financial system can be squeezed to finance the burgeoning American current account deficit because no nation has ever, since the advent of central banking, been in quite the position Japan is now in. The Japanese government is now accumulating dollars in huge tranches, billions at a go. Rightly or wrongly, the Japanese government evidently believes that it has no choice but to follow Washington's lead.

That lead is becoming more and more uncomfortable. Last Friday the US tabled a draft resolution at the United Nations that if passed will effectively sanction unilateral US rule over the country. It would dismantle the oil-for-food program and channel oil revenues into a "reconstruction" fund. It would explicitly recognise the US and Britain as the occupying powers for a period of one year, automatically renewable unless the UN Security Council votes to terminate their mandate. Given that the US and Britain both wield vetoes, this is tantamount to giving them an indefinite mandate to run the country. Crucially, the draft resolution mentions nothing about existing Iraqi liabilities and contracts, which leaves France, Germany, Russian and China, which all are owed money and have such contracts, in limbo. It is clear that the US proposal is tantamount to a take it or leave it ultimatum.

There is no reason we think to believe that any of these countries are likely to accept a humiliation that effectively means that money that they are owed flows into the coffers of Bechtel, Halliburton, Dyncorp and other American firms awarded contracts in Iraq. On the contrary, it is highly likely that they will only redouble their efforts to undermine America's regional military offensive. Russia is said to be funding the Talibanin Afghanistan, and has been cooperating with China to pool oil and gas resources. France and Germany have established a new command and control structure for joint military operations independent of NATO. The deteriorating international situation was summed up by German State Secretary Jürgen Chrobog, who dubbed the US a "police state."

The US embassy in Bonn tersely and somewhat cryptically averred, "Someone has made a big mistake."

The Fed and the Treasury have their work cut out for them. It is all very well to lower interest rates, steepen the yield curve and deliver a surge of profits to the banking sector. The falling dollar will undoubtedly deliver an exchange gain to corporate profits overseas. But the idea, current in some Washington circles, that the falling dollar will somehow "punish" France and Germany for their opposition to American ambitions is simply ridiculous. On the contrary, America is putting the floating fiat dollar reserve system that underpins its military machine at risk. As the dollar falls, the odds are rising of the international markets reaching what one investor we know called "the riot point." On current trends, the US is going to soon face the necessity of some form of controls to prevent a cascade of flight capital from the US markets. In the light of this, the attempt by some congressmen to tilt the reduction of taxes on corporate dividends in favour of US companies at the expense of foreign firms may be a sign of things to come.

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