Broadly speaking, it's a merciless war between inflation and deflation. But there are many different attacks, ambushes, counterattacks, feints, and massacres going on.

The Dow retreated 173 points yesterday. Typically, following a major fall in the stock market, there is a 'reflex rally' that lasts several months. Our rough guess was that it would carry on until summer. Most analysts thought it would exhaust itself sooner. Who knew? But yesterday, it looked as though the rally may be nearing an end.

The rally itself is a part of a larger battle between two contradictory body parts - the heart and the mind. The heart wants to believe that the worst is over. It reacts sentimentally, remembering the glory days of the great bubble era and wishing they were back. Higher consumer confidence readings sent the stock market higher on Tuesday - the heart ruled.

But on Wednesday, it was the head's turn. The head looks at the facts: housing and employment are still going down. People will spend less money. Businesses will make less money. Ergo, no reason to expect stocks to go up. Instead, they're more likely to go down. The Dow scurried back to the lines it occupied at the beginning of the week.

The head noticed, too, that the Treasury market is getting slammed by higher yields. The long bond yielded 4.56% yesterday - up from well below 3% at the end of last year.

"Treasury yields give cause for concern," says this morning's Financial Times.

"Rising Treasury yields threaten to stifle economic recovery," continues another article in the same paper.

But has the top of the bond market really passed? Is the credit cycle now in full retreat? Will homeowners and businessmen be tortured with higher interest rates?

Those are the questions the head was asking yesterday. And it didn't like the answers. If there were any green shoots, it reasoned, higher interest rates could crush them.

At the end of last year, America's great buddy, China, changed its policy. Instead of buying long-dated US debt, China began buying the short stuff. China's top man openly wondered whether the US would be able to protect the value of the dollar and keep its promises to foreign lenders.

"We have a huge amount of money in the United States," we quoted China's premier just yesterday. He reminded the US that China had entrusted a lot of its wealth to US paper and went on to request that America respect its obligations to bond buyers. Obviously, the Chinese must wonder if the US is capable of protecting its currency while still funding its war against deflation.

Tim Geithner promptly responded. "Yes we can!" But the Chinese cogitated on the matter... "No they can't," they began to think. Then, they switched to buying short-term US debt, leaving the longer-term bonds to other buyers. Since the Chinese were the biggest buyers at US Treasury debt auctions, this switch in policy had a quick and noticeable effect. Bills rose. Bonds fell. The yield on bills fell to below zero, while the yield on the 30-year bond has gone steadily up.

If America's supply lines to cheap credit have been cut, she is at a great strategic disadvantage. Or rather, her pre-existing strategic disadvantage is becoming more apparent: she depends on foreigners just to be able to continue living in the style to which she has become accustomed. As the president of the United States of America acknowledged this week:

"We're out of money now."

But how does this affect the war between inflation and deflation?

The US is on the side of inflation, of course. It put its whole economy on a war footing and has earmarked more resources (in real terms no less), to the fight than it spent on WWII.

In a larger sense, the US is at war with capitalism...and with nature herself. Markets have natural rhythms. They go from boom to bust...from inflation to deflation...from expansion to contraction naturally. Trying to stop the bust is futile. It is a fight against Fate...a losing proposition. And it is diabolically unnatural. You have to take the bad with the good in life. There's no going to Heaven without dying. And you can't rebuild a house without tearing down the old one. Mistakes must be corrected. Old, worn-out businesses have to go out of business so that new ones can take their places. Bad investments need to be deflated...liquidated. Failed managers and failed business models must be eliminated. Bubble delenda est.

The feds can't beat nature. The bubble can't be reflated. They can't make the situation better than it would be if they left it alone. But they can make it a lot worse.

They still have the nuclear option. Then we'll all be blown to Hell...

As you know, the battle between inflation and deflation is going badly for the feds. Deflation is winning. And yesterday, the Eastern Front collapsed.

Germany announced that consumer prices are now 0.1% lower than they were a year ago. Germany is in outright deflation. The rest of Europe is probably not far behind.

In America, the trend is probably in the same direction. The money supply - M1 - grew at an 18% rate over the last 6 months. But taking just the last 3 months, the rate of growth has fallen to only 1.8%.

Meanwhile, the US Treasury is borrowing hundreds of billions' of dollars in order to close the gap between what the US spends and what it receives in taxes. Even if the Chinese are willing to fund that borrowing in the very short term, it just pushes forward the inevitable day when the list of willing lenders is shorter than the list of US Treasury bonds to be sold.

When that happens, the Chinese can bend over and kiss their reserves goodbye. Because there is no way the US government is going to forego spending money just to protect foreign bondholders. Instead, to raise money, it is going to turn to its very own bond buyer of last resort - the Fed.

The Fed will "monetize the debt" - by buying Treasury debt and converting it to dollars in circulation. At least, that's the plan. The risk is that it will cause consumer price inflation. Everyone is aware of the risk. Few doubt that it would happen.

"Harvard University's Ken Rogoff and Greg Mankiw think more is better when it comes to inflation.

"Rogoff said he advocates 6 percent inflation 'for at least a couple of years.' That would alleviate the strain deflation imposes on debtors, including the U.S. government, who have to pay back their loans in appreciated dollars.

"In the Middle Ages, they threw people who failed to repay their debts into debtors' prisons. Today debtors are rewarded with all kinds of government perks. Look how far we've come!

"Borrowers took out mortgages they couldn't qualify for to buy homes they couldn't afford. When the housing market collapsed, they were rewarded with government-subsidized mortgage modifications and, in some cases, partial forgiveness on their loan balances. And now, under Rogoff's 6 percent solution, debtors would see more of their burden lifted.

"And we, the savers, get screwed again.

"And who says the Fed can orchestrate 6 percent inflation and not let it get out of hand? You know what would happen to those well-anchored inflation expectations: Ahoy, matey, it's out to sea with you.

"'Trying to manage a slight increase in the rate of inflation in a discretionary way is not practical,' says Marvin Goodfriend, professor of economics at Carnegie Mellon's Tepper School of Business in Pittsburgh.

"Mankiw didn't specify his preferred inflation rate in the Bloomberg story. He was too busy to give me an interview, directing me instead to his New York Times column from last month where he proposed the idea of negative interest rates: not negative real rates, adjusted for inflation; negative nominal rates.

"The idea is 'to make holding money less attractive' so people will spend it."

Needless to say, we can't wait to see what happens. The Chinese already seem to think that holding dollars is less attractive than it used to be. But Geithner and Bernanke assured Wen Jiabao that his money was safe. We wonder what he'll do when he realizes they played him for a fool.

Bill Bonner

The Almighty Dollar
by Bill Jenkins
Pylesville, MD


After last week's thumping at the hand of all its major counterparts, the dollar is looking to me like Charles Atlas' 98-pound weakling from the old comic book ads. Sand is getting kicked in its face from every bully on the beach. Even the lowly yen, with its pacesetting negative GDP (a negative 250% of the United States), is kicking the dollar's bootie.

When this rot began to be exposed, I often reported that things had been turned on their head in the currency world. Bad news for the U.S. economy became good news for the currency. Why?

Basically, risk aversion settled over the market. People and governments were fearful. And since currencies tend to be considered risky investments, investors avoided them. In short, the worse the news for the U.S. dollar was, the more money flowed into the it.

But you cannot, under any circumstances, run contrary to the law of supply and demand forever. It's just impossible. Therefore, at some point, a return to fundamentals reverses the current perverted trends.

And as of last week, fundamentals have showed back up on the stage. For the first time in a long time, investors are treating bad news for the dollar as bad news for the dollar. So let's take a peek here and see what we have.

Initial jobless claims rose again last week. This time to 637,000, which was higher than forecast and the previous week's number, was revised upward. In addition, continuing claims for unemployment came in higher as well - 16 straight weeks of increases.

The Federal Open Market Committee also hung the markets out to dry. You see, the Fed heads discussed the weakened condition of the economy at their meeting. They also revised their economic projections for 2009 and 2010 lower.

Here was the key. They DID NOT PURCHASE as many Treasuries as the markets believed they would - part of the infamous quantitative easing. Now, at first blush, we would be happy about that. But once we lift the Feds' curtain on this act, things are not what they seem. The market's reaction assumed that a less-than-stellar bond purchase number portends that the Fed will have to purchase more later on.

At this point all factions are feeling the squeeze.

The Feds know they cannot continue to inflate as they have indicated. While runaway inflation remains a threat, the bigger problem is whether or not traders and investors (including the sovereign states that buy our debt and support our spending addiction) will pull the plug on the dollar.

If such massive selling occurs, that only leaves them the option of perpetually inflating the currency, since borrowing becomes out of the question.

Nobody wants to be the last one out the door once that begins. As of now, the Fed still has a little opportunity to actually control the hyper inflation scourge, but if they tip the scale just a bit too much and the selling begins full force, control will be out of their hands entirely.

Interestingly, the whole tenor of the minutes from the Fed meeting indicates that the worst is still ahead. Yet Ben Bernanke and company are still telling the public about "green shoots" - small signs that things are improving.

Bill Bonner shares a headline from Politico last week: "Obama Would Regulate New 'Bubbles.'"

Oh, the sheer absurdity of it all! We have a government that doesn't even seem to know where bubbles come from. They don't know how they work. They don't know why they keep inflating. They don't understand why you can't deflate them slowly. In short, an administration with a rudimentary understanding of economics is confident it can regulate the next bubble - whatever it might be.

But I suppose that is the plan of all governmental types. Whatever doesn't work needs more regulation.

What we need is to be left alone. The market has been, and remains, the most efficient system for regulating itself. Is it perfect? Not in a moral or theological sense. Not even in a fairness sense. The market will make some men rich while impoverishing others. Many people do not consider that "fair." But it doesn't matter. The market does what it does, because it is the most efficient way to do things. Regulation be hanged, the market will undo regulation and tyranny, because free markets create free men. And on its way to undo the foolishness of men, it will cause great inequalities. Why? Because of the foolish restraints that governmental do-gooders have foisted upon it in the name of "fairness."

The ironic thing is, bubbles are created by regulation. You can't undo them with more of the same.

Since the government has had such a great track record with spending and credit, now they want to get their greedy little paws into the credit card business, too. Apparently, it's not enough for them to control the major banks, or the once monstrous auto industry. The heady days of markets free from governmental interference are going the way of the dinosaur.

Our Senate, by an overwhelming majority, passed a new bill that would dramatically impinge on the credit card company's policies to alter rates and fees.

Now, I am not going to bat for the credit card companies. Frankly, they have abused people for years. As a younger man, I, too, enjoyed the pleasures of free money being offered by these benevolent giants. Every time my wife and I got a new card, we treated it like a raise.

Before long, the handwriting was evident on the wall, and I didn't like what it said. So we got out. Don't get me wrong, I still use my credit cards. But they no longer own me. Yet the number of my friends and relatives who are slaves to these things is atrocious. In sum, I have no love loss for these companies and how they try to enslave people.

But I will stand and declare their right to do it as a free market entity as long as people will keep applying. The fact is, if and when the credit card companies get "out of hand," the market will reign them in. We don't need the government to do it. They won't do it well anyway.

Meanwhile, the Federal Deposit Insurance Corporation (FDIC) suffered its biggest bank failure of 2009 last week. Bank United FSB, Florida's biggest regional lender, performed its final curtain call. Having over $20 billion in assets and deposits, it's the biggest flop of the year, and the second biggest of the whole credit crunch (Indy Mac still has that award).

Bank United’s failure will take a $4.9 billion chunk out of the FDIC's checkbook. It is the 34th bank to fail in the first five months of this year alone, compared to 25 for 12 months last year. A green shoot? Not hardly...

So on the edge of this knife, Big Ben and the Fed have to balance. That is, the Fed has to sell $3.25 trillion in Treasuries to fund this year' obligations between now and September.

If the markets can absorb the U.S. issuance over the next 90-120 days...and if it is done without driving up interest rates...and if the economy begins to show signs of positive growth... then the stage is set for a wonderful second act. (And Bernanke might win an Oscar!) The dollar will return to strength. The market will continue, or resume, a climb to the top - sensing that "everything is coming up roses." Refinancing will surge ahead. We may even see significant job creation into the end of the year.

At that point the Fed must begin to worry about inflation. Will the infantile recovery be strong enough to fight off a bout with interest rate increase flu?

I wouldn't bet the farm on that.

On the other hand, if Treasury rates continue to rise as they already are, and the Fed is forced into extensive quantitative easing to contain them, then it may very well be curtains for the dollar. And the critic's reviews won't be kind.

Earlier this month, the dollar index fell below its 200 DMA for the first time since July 2008, and has been falling ever since. Not long after, the euro and sterling popped above their 200 DMA.

Of course, there's probably a good reason why. The world is beginning to notice the U.S.'s monetary policies. Our rising deficits are eclipsing Mount Washington. Those deficits are going to need financing. And right now, the government doesn't care - it's still behaving recklessly because it thinks people will always be ready to buy its debt.

I wouldn't be so sure. Consider the credit rating of Great Britain. Standard & Poor's changed the outlook on the United Kingdom from stable to negative. Now, that's not the same thing as a rating cut. But it does betray that the rating agency sees the nation on the wrong path. Continue on that path, and the outcome is guaranteed.

It doesn't take an advanced degree in logic to apply the same principle to the United States. Indeed, I have wondered if all this was orchestrated for that purpose alone. It is far less damaging to downgrade a substantial nation like the United Kingdom than it is to downgrade the world's reserve currency economy... the very definition of value.

But if it can happen in the United Kingdom, the United States had better be prepared. To that end, we heard Bill Gross, from PIMCO, the world's largest and most influential bond trading firm; say that he believed the United States would eventually lose their AAA rating.

That's scary stuff - but not all that surprising. After all, the administration is predicting a $1.8 trillion budget deficit. Perhaps more.

And where is GDP going? How much will it grow this year for all that fuel being added to the fire? It's like adding a cast of thousands to a one-man show, just to try to give it a bigger billing. The expenses become monstrous, but no more people show up to pay the admission fee.

But the directors just want to keep adding more actors. At that point, the expenses of the show run absolutely in the opposite direction of the of the income. Until soon, the producers default on their lease, the curtain falls on the show and the affair is over.

When will the U.S. show be over?

Hard to say. But when your expenses are 650% of your income, it can't go on for long. Not only is the curtain falling, the whole theater is collapsing around us. Better make sure you have a clear shot at the exit.

In fact, some U.S. businesses already are.

My home county has a few decent sized towns, but for the most part is still rural. Our biggest claim to fame is a section of famous U.S. Route 1 - the first route to run from New York to Miami along the East Coast. On our section of Rt. 1 has an abundance of auto dealers. But recently, the largest one put out one of those fancy electronic message boards. The advertisement read:

"NOW TAKING GOLD AND SILVER FOR YOUR VEHICLE DOWN PAYMENT."

I'm pretty sure they'd be just as happy to take it for the entire payment as well. So who needs the U.S. dollar after all?

Regards,

Bill Jenkins
for The Daily Reckoning