The Washington Dream Factory

01/27/2011 1:34 pm EST

Focus: MARKETS

Axel Merk

President and Chief Investment Officer, Merk Investments, LLC

The Federal Reserve’s insistence on growth at all costs will add to gold’s shine once investors wake up to a painful reality, writes Axel Merk of Merk Investments.

The Wizard of Oz would be proud of our policy makers. Let's enjoy the dream for a moment: the Federal Reserve has sprinkled money on the economy, Congress has kept taxes low, and we see signs of a recovery.

A recovery driven by consumers with more disposable income. Where do they get it from? The reduced payroll tax? Maybe, but how about all the money consumers have at their disposal now that they have stopped paying their mortgage? What a wonderful life this must be!

The Fed’s All In
Because the Fed doesn't quite believe in the recovery, we believe its latest bond buying program will run its course—Fed Chairman Ben Bernanke has repeatedly stated that one of the grave policy mistakes during the Great Depression was that monetary policy was tightened too early. He appears committed to not letting history repeat itself; investors may want to trust him on that, as well as his commitment to push inflation higher.

Ultimately, the Fed would like to engineer higher home prices so that consumers are no longer "under water." The challenge the Fed has, of course, is that while it can create asset inflation, the Fed has a difficult time influencing which assets inflate.

Having said that, the Fed has at least some success: Easy money has pushed some companies’ valuations higher. Just look at Facebook, now valued at $50 billion, which may bode well for Palo Alto real estate. This is the Fed's contribution to the wealth gap: those with assets may do well under Bernanke's leadership.

Congress in the meantime will do what it does best: talk. There will be lots of it. Specifically, the debt ceiling may be the talk of the day, month, and year. The new spirit among Republicans is to stop wasteful spending. But let's remember that the grand compromise on tax reform did not require anyone to make tough choices. Washington wizardry is in full swing, make no mistake about it.

Calling Bond Vigilantes
Don't look for the Fed or Congress to disturb the dream. The bond market may need to be called upon to rattle us. As the first signs, investors my interpret falling bond prices as a sign of economic recovery; but as the sell-off may continue, the chief Wizards may be called upon to do something about those mean speculators that dare to wake us up from our dream world. Think volatility, think falling dollar.

The bond vigilantes have already arrived to wake up European governments. It may only be a matter of time before the US gets its wakeup call. The question is not whether there will be bailouts for some states, but what strings will be attached to them. Let's also remember that the US is more vulnerable because of its current account deficit; the Treasury market may be at risk of following the municipal bond market's decline.

It turns out that Bernanke's dream has real implications for the rest of the word. Asia is waking up with a hangover called inflation. Indeed, while the US is in denial about inflation—after all wages are not budging—the rest of the world has started to tighten monetary policy, including the Eurozone, where hundreds of billion in euros have been mopped up.

Don’t Sell Short the Euro
In the meantime, Europe has wiped its eyes and is now wide awake and alert. In Europe, this doesn't translate to swift action, but may well lead to a process in which weaker states cede control of their budgets in return for aid. While not a perfect process, when coupled with expected restraint from the ECB, this could well turn the euro into a champ this year. A widely disliked investment such as the euro may hide a lot of value.

As far as gold is concerned, the continued concerns over sovereign solvency—not the Eurozone in particular, but globally, combined with the US drive to achieve growth at any cost, make the yellow metal worth considering. Is your yellow brick road made of dreams or gold? Just because policy makers are dreaming, doesn't mean investors need to.

Read more commentary from Axel Merk at the Merk Mutual Funds Web site here…

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