Bernanke and Paulson talking bull to support the dollar

For the past few years American policy makers have been talking of a strong dollar while doing nothing to prevent the fall of the greenback to stimulate exports and reduce the national debt. You would think the markets would therefore be less and less impressed by the bull from New York and Washington.

And yet over the past week Fed chairman Ben Bernanke and Treasury secretary Hank Paulson have been successfully talking the dollar up, with the Fed hinting at higher interest rates, and the market actually pricing in a couple of rate hikes before the end of the year. It should get ready for a big disappointment.

All this policy bull does not disguise the true state of the US economy, which even the boldest, most naïve American optimist, is beginning to perceive. Unemployment was up by 0.5 per cent last month. House prices are falling at the fastest rate in history, and show no sign of bottoming out for 12-18 months. Energy costs are soaring for a nation that drives to work.

Now what comes next: A spontaneous strengthening of the US dollar? A sudden recovery in the economy? An end to inflation? It is all just wishful thinking.

The typical length of a financial crisis is three years. How long did it take the Asian countries to emerge from their 1998 crisis? First, you have to see a market bottom, and the US just has not got close to seeing its bottom. Indeed, there are several more down stages to come.

With inflation surging due to lose monetary policy designed to offset the impact of falling house prices on the balance sheets of the Wall Street banks, then we should expect to see the bond market crash. Inflation is deadly for fixed-return assets like bonds whose value withers away in real terms even in the absence of interest rate increases.

At the same time Wall Street looks exceptionally vulnerable to a crash in stock prices. Inflation and recession is a toxic cocktail for company profits, and market capitalizations of major stocks will have to be re-set to compensate, especially as global economies weaken later in the year and the export boom recedes.

Then Bernanke will have to eat his words and dine on his own credibility and cut interest rates in response. That is perhaps why he has left interest rates at two per cent, and not gone for one per cent straight away. He is keeping some ammunition for the next stage of the battle.

But once interest rates fall that is it for the US dollar. As another article on this website argues, we are set for the $2 euro and $3,000 an ounce gold and $200 silver.

Whatever the hopes inspired during the presidential election campaign this autumn the realities of the marketplace for whoever is unfortunate enough to win the key to the Oval office are dreadful for 2009. The bottom will come in 2010.