It’s no surprise that the U.S. dollar is finally mustering a bear market rally (in truth, our currency experts have been predicting a dollar bounce for quite some time).

And it’s no surprise that gold prices are pulling back, either - we’ve been waiting for that pullback too.

But what is quite shocking is there’s now a general consensus on Wall Street and in the Federal Reserve that we’re approaching the end of this easing cycle.

Investors are growing increasingly optimistic that the United States will escape this recession quickly. They think this currency crisis will be similar to the 2001 recession. I think they’re dead wrong.

Never mind that housing prices are still plunging, job losses are mounting each day at major corporations and we’re in the middle of a contraction in credit for both companies and individuals. If you factor all that in, it’s lunacy to believe the Fed has reached the end of this monetary easing cycle. In fact, I am projecting the Federal Funds rate will head to at least 1% or maybe even 0% before this bear market is over in 2009.

The Biggest Sucker’s Rally Since April 2001

Why am I so bearish? This economic cycle marks the first time in the post-WW II period that inflation and deflation are running side by side. It is unprecedented. Consumers are spending less, losing their jobs and banks are denying credit. Also, soaring food and energy costs are killing consumers’ discretionary funds.

Housing, however, is my primary concern. New home sales tanked 8.5% in March to their lowest levels since 1991. Housing shows absolutely no signs of bottoming. In my opinion, that’s the biggest deflationary tug on the economy.

What we are seeing now is a long overdue bear market rally for stocks, including the homebuilders and REITs. This is the biggest sucker’s rally since April-May 2001.

After topping out earlier last month at US$1,033 an ounce intraday, the June gold contract has pulled back to US$887 an ounce Friday morning in New York, a 14% decline.

This marks the second time in six weeks that gold prices have corrected below US$900 an ounce on the heels of a U.S. dollar rally. The dollar, of course, has been dumped relentlessly for the last several years with a brief bear market rally in 2005. This time will be no different.

Central bankers are putting enormous pressure on the Fed to stabilize the dollar. You can understand why. With the cheap dollar, inflation is now spreading just about everywhere.

The Fed talks a good game, but in the end has no choice but to grow the money supply to arrest housing and credit deflation. The broadest monetary aggregate available to the public, M2, shows a massive 16% gain year-after-year. That tells me the Fed is desperate to grow inflation at all costs.

Buy Gold If It Falls Anywhere Near US$850 an Ounce

I would use any intermittent weakness in gold prices to accumulate positions. Gold should hold above US$850 on this correction. Supplies remain very tight, especially in South Africa. Plus, new mined supply is virtually nil. The major gold mining companies have to shell out huge input costs to replace declining reserves or net new supplies.

In 2005, gold prices rallied 18% even as the dollar posted a bear market reversal. I expect the same to happen this year, especially as the European Central Bank (ECB) starts cutting lending rates over the second half of the year.

As the ECB starts cutting, gold will head off to the races once again as that part of the world joins the Fed in reflating the money supply. Germany is now slowing and several other countries are faring even worse, because they’re already suffering from real estate deflation.

Investors have seriously miscalculated a bottom in financial markets. The Bear Stearns bailout was not a “buy” signal. Instead, it marked an acceleration of desperation as the Fed prints money like there is no tomorrow. The war is against deflation. Buy gold on weakness.

ERIC ROSEMAN, Investment Director