-- Posted 29 April, 2011 | | Discuss This Article - Comments:

Investors don’t know what to do with commodities.  Traders are asking, “is it too late?” and “have we gone too high?”  The question, of course, isn’t easy to answer, but the simple reality is that there won’t be too high of prices until the dollar becomes too low.

In light of recent events around the world, the Fed has remained incredibly lax in its policy to push interest rates and the dollar to zero.  Most every central bank has tightened, is expected to tighten, or must tighten (think China) to keep their currencies from plunging to zero.

But we have a very interconnected world commodities market, and unfortunately for investors in the United States, that commodity market is mostly priced in the currency that is falling the fastest: the US dollar.

Each Foreign Rate Hike is Dollar’s Loss

From a hot air balloon view of the world financial markets, it is quite easy to see the macro picture that low rates, enforced by inflationary policies, ultimately bring lower currency values.   What often gets blurred in this picture from 2,000 feet, though, is that the foreign currency markets ultimately settle disparities between what the central banks see and what the world sees.

Case in point: the persistent carry trade.  With each rise in interest rates around the world, it becomes increasingly advantageous to borrow in dollars to lend in other currencies.  The best example for this particular effect is the Australian dollar’s value against the US dollar.  As the Australian economy revived after the global financial crisis—you might make the case it never actually consolidated—the rise in commodities boosted this commodity producing nation.

So what did the Australians do?  They raised their interest rates, even though they had already one of the highest interest rates of all the credit-worthy nations.   Investors, sensing opportunity, knew that they could borrow at near-zero in dollars and lend to Australia at just under five percent, so that is exactly what they did.

Now, the effect is even further felt for Americans.  Rising commodity prices, which are a direct result of the dollar’s decline, are now encountered two-fold. Prices are higher, and their interest earnings on traditional investments are even lower; thus, income plummets, especially for seniors, and the relative value of their purchasing power further declines.

No Time for Traditional

Traditional investments work 99% of the time, and when they work, they do quite well.  Throughout history, of course, you would have been best to invest in equities, solidifying your portfolio with partial ownership of the productive capacity of growing businesses.

Today, traditional investments are worn out.   They’re priced at higher earnings ratios than ever, and yet still haven’t reached their peak.  Cheap cash has made owning a slice of world commerce less expensive, and ultimately it has been equities that have risen to bridge the gap between risk, reward, and profit.

There is no better time, despite soaring prices, to buy into silver as a life-long investment.  Whereas low rates have made stocks expensive, they have also made silver expensive.  But what will happen when interest rates finally rise?  The cost of borrowing, which has allowed for rapid expansion of price-to-earnings multiples, will be inverted, and what was once the benefit of equities will be their downfall.

At the opposite end, rising interest rates will give way to even greater concerns about debt loads, lead to higher costs of borrowing, and ultimately new contagion fears that transcend finance and global business, and penetrate deep into government pocketbooks.  Consider, just for a moment, what a minor rise in interest rates will do to the trillions of dollars in fixed-income assets that are currently priced at a 4-6% rate of return?

Let’s look at mortgage-backed securities issued 5-years ago at a 7 percent interest rate.  These securities, compounding monthly, would sell for a bond price of just under $1300 with accrued interest of $350, and coupon rates of 7% per year with a current yield of 5%.

But what happens if yields rise to…say, 7%?  Instantaneously, the price of the bond is now only $1067, for a capital loss of $233.

Why is that such a big deal?  Well, for one, all of the interest owned by investors is practically null, but most importantly, it means that any exit by any central bank will be just as inflationary as the entry.  Accrued earnings will sell for less than they’re worth, and the Fed, among others, will lock in losses that result in guaranteed inflation.

At that point, it will be only higher rates that can stop the bleeding, and higher rates will only result in a dead economy.  The cat is out of the bag: fixed-income is certain to plummet, and there is not a single exit strategy for the global banking system.  Your exit strategy from the coming catastrophe is quite simple: silver bullion.

Dr. Jeffrey Lewis

www.silver-coin-investor.com