Dollar Down, Gold Up

Dollar Down, Gold Up

As an unintentional extension to an earlier post (Dollar Down, Everything Else Up), I want to use this post to highlight the appreciation of gold in particular, against the Dollar. After a brief decline following the credit crisis, Gold has resumed its upward path. It has appreciated 15% year-over-year, and recently cracked $1,000/oz for the only the fourth time in history.

The general factors behind the price of gold are too broad and numerous to be captured in this post. In addition, many of these factors have little to do with currencies (including the Dollar), and thus don’t warrant much space on a blog devoted to forex. At the same time, conspiracy theorists, doomsday predictors, and even some mainstream economists have long argued in support of gold as a hedge against inflation (otherwise understood as currency devaluation). In fact, I am only posting about gold now is because that notion has become much more popular over the last few years, to the point where pundits have come to see the current appreciation almost solely in terms of the decline in the Dollar.

That’s because many of the more conventional factors – the same ones that affect prices for other commodities – suggest that gold prices should be declining. Non-speculative demand (i.e. jewelry, industry) remains subdued as a result of the economic recession. Speaking of which; while there is now some evidence of recovery, it is nowhere near robust enough to support a return to bubble prices. In addition, the International Monetary Fund (IMF) just approved a massive sale of its gold reserves, equivalent to 15% of the world’s annual gold production.

Yet the price of gold remains not only stable, but positively buoyant. According to analysts, this is because of an increasing sense of anxiety about the viability of the Dollar as the world’s reserve currency. Euro Pacific Capital’s Peter Schiff, an effusive source of commentary on the markets, believes the price of gold will skyrocket to $5,000 per ounce. “Schiff’s forecast is based on his view the U.S. dollar is going to collapse under the weight of our massive deficit and reckless policies of the Obama administration, which he compares to the massive spending programs of the 1960s, which paved the way for gold’s ascent in the 1970s.”

Other analysts take Schiff’s view one step further by arguing that a shortage of viable alternative reserve currencies (Euro, Yen, Pound, Yuan, etc are plagued by similar fundamental flaws as the Dollar) makes gold the best candidate to replace the Dollar. Some people even hold the extreme view that the entire fiat monetary system will collapse, with the result being a barter system centered around gold. In any event, people are nervous: “That means a growing number of investors, traders — and, most troublingly, foreign governments — don’t believe in the strength of the U.S. dollar, analysts warn. People buy gold when there’s fear.”

On the other hand, it seems reasonable that gold is appreciating for the same reason that everything else is. In this sense, rising gold prices are hardly remarkable. Silver and platinum, for instance, have risen nearly 50% year-after-year, despite similarly weak fundamentals. There is a danger in connecting the Dollar’s decline too closely with the rise in gold, since the former is largely a function of short-term factors such as low interest rates and increasing risk appetite. “With the Fed confirming that interest rates could be steady for a long time, the dollar may continue to be dumped in favor of higher yielding currencies, which may favor the yellow metal.”

While there’s reason to be alarmed or even angry about deficit spending, quantitative easing, money printing, and unsustainable debt, there’s very little to support the notion that inflation is taking hold. In fact, based on both Treasury bonds and inflation securities, inflation is the last thing on the minds of investors. In addition, while gold represents a conceptual reserve commodity, it’s not very practical. It has very little utility (especially compared to other commodities), and its supply can be easily manipulated by producers and central banks. One analyst explains, “Even a rather wobbly reserve currency is better than gold. Gold is far less liquid than U.S. Treasury securities, costly to store and insure, and above all more volatile in price.”

Still, perception is reality in financial markets. If investors want to see a connection between a weak Dollar and strong gold, they will simply contrive one. But if the Fed raises interest rates and/or the Dollar stabilizes, you can expect gold prices to follow suit. If this happens, it won’t imply that confidence in the Dollar has been restored. Instead, it will only imply that investors can earn a higher return investing in Dollar-denominated assets and no longer need to speculate in gold.
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Posted by Adam Kritzer | in Features, US Dollar | 7 Comments »
Dollar Down, Everything Else Up
Sep. 21st 2009

Since March, the financial markets have been characterized by several generalizable trends, which can pretty accurately be distilled into the title of this post: Dollar Down, Everything Else Up. To illustrate just how intertwined these two trends are, consider that on the same day, “U.S. stocks rose, sending the Standard & Poor’s 500 Index to an 11-month high,” and “The dollar slid to an almost one-year low.” Two perfect to be a coincidence. Look at the charts below, which show the performance of the US Dollar and Emerging Market Stocks, respectively. Subtract out the stochastic fluctuations, and you’re left with two mirror images!

charts

In this case, connecting the dots is not difficult. In fact, I don’t know of any analyst that has argued against an airtight inverse correlation between the Dollar and virtually every other commodity/security/currency. A solid explanation can be found in an earlier Forex Blog post “Dollar Under Pressure on All Fronts,” which detailed both the short-term and long-term drags on the Dollar, but I’ll summarize and expand upon it below for those of you who didn’t read the first iteration.

In the short-term, the Fed’s easy monetary policy is one of the most salient factors. It has injected more than $2 Trillion in US capital markets since the start of the credit crisis, and lowered interest rates close to 0%. In fact, the Dollar is now the cheapest funding currency in the world, recently eclipsing Japan, the perennial home of cheap capital. Moreover, US rates are expected to remain low for the near future. According to one analyst, “Congressional elections in November 2010 represent a strong incentive for the Fed to stand pat. That is because going into an election, there often is political pressure to keep rates low and give a boost to the economy.” This belief is reflected clear in US Treasury rates, which remain relatively close to the all-time lows touched in 2008.

_tnx
In other words, it’s a classic carry trade scenario, with the US footing the bill. Of course, there’s a twist, namely that there’s so much cash floating around the system, that all of it can’t be invested abroad. Hence, the whopping 58% rise in the S&P 500, from trough to present, as well as the recovery in gold, oil, and other commodity prices. You will find plenty of analysts who point to impressive graphs and quote equally impressive statistics to explain these seemingly distinct instances of appreciation. But from where I’m standing, the fact that everything is under the sun (except for real estate, but that’s another story) is rising would lead the proverbial alien watching from outer space to conclude that investors have adopted a bubble mentality, and are once again chasing returns wherever they can be found.

The strongest support for this explanation can be seen in the fact that signs of US recovery have not been accompanied by Dollar strength. By most estimations, the US economy is now stronger (despite the employment picture) than the UK and the EU, at the very least. Yet the Euro and British Pound have far outpaced the Dollar over the last few months, picking up steam once again over the last few weeks.

You don’t need me to tell you that this is a product of risk aversion; that, ironically, signs that the US economy is strengthening/stabilizing causes investors to move capital out of the US economy. If investors were betting on fundamentals, as stock market bulls would have you believe, this would be plain irrational. But the fact is, US economic growth makes investors more confident in global growth, and causes them to turn towards more speculative investments to achieve yield.

In analyzing whether this phenomenon is sustainable, then, it doesn’t make sense to look at the different markets, in isolation. Rather, you must be holistic in your approach, basically by examining whether investors are justified in their overall complacency. If ever it was the case, it certainly is now: perception is reality.