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It is becoming clearer that higher
gold prices are tracking prospects for further devaluation of the U.S.
Dollar. This is a result of the falling relevance and global stature of the
U.S. economy, military and political cohesiveness. The stability of gold
as a currency provides one of the best and most immediate polls on the
direction of a nation’s future.
Gold has broken away from the
seasonal pattern of flat to declining prices over the summer in each of the
last seven years. This may have been a good indication that monetary easing
in 2008 was beginning to circulate through the economy, increasing liquidity
and the money supply. This presumed increase in liquidity could have
been a reason for increases in the price of gold and the Dow. Not
surprisingly, the rate of money circulation is anemic, as evidenced by low
demand and supply of credit. It appears that liquidity may not be finding its
way into either reported inflation indices or growth in gross domestic
product (GDP). Without signs of reported inflation or credible signs of
a return to a robust economy, the Federal Reserve has little impetus to
increase interest rates, making the U.S. dollar less attractive. The
gold price and the level for the Dow have achieved higher valuations even as
the U.S. dollar depreciates relative to those assets.
The perspective that higher gold
prices are not due to either inflation or lack of economic growth in the U.S.
does not mean that inflation is not in our future. Simply from a U.S.
perspective, gold did not become more valuable, but rather, the U.S. dollar
lost value. Considering the United States lack of manufacturing and
dependence on imports, higher inflation in the U.S. appears certain.
Internationally, very real concerns exist over the U.S. deficit and its level
of debt to GDP. While interesting today for traders and speculators, these
trends may have very real implications for the economy and future of the U.S.
On the present course, even at historic highs, hedging against inflation or
further devaluations of the U.S. dollar with gold and gold equities appears
to be a reasonable strategy.
Low Interest Rates are Driving
Down the U.S. Dollar
On October 6, 2009, the Australian
central bank became the first to increase interest rates following the global
downturn. The increase of only 25 basis points had a profound impact on the
U.S. Dollar, the Dow, and the price of gold. Countries such as Australia,
Israel, Norway and Brazil were somewhat isolated from the downturn and are
the most likely to halt quantitative easing by increasing interest rates.
Specifically, those countries whose economies are largely resource based such
as Australia, Norway and Canada also have additional flexibility to reign in
excess liquidity to prevent inflation and strengthen their currencies, thus
making themselves more attractive for foreign investment.
The increase in interest rates in
Australia makes investing in their currency more appealing relative to the
U.S. dollar. Low interest rates in the U.S. make it attractive to borrow
and sell dollars and buy the more speculative higher yielding currencies of
Australia or Canada. This lowers the exchange rate of U.S. dollars relative
to other currencies. In addition to arbitrage, the initiative shown by
Australia in increasing interest rates demonstrates that the global recession
is being regionalized, and national economic policies are undergoing
increased scrutiny by international investors. Oddly, an increase in interest
rates in Australia demonstrates economic stability and increases its
desirability for investment by foreign capital. The relative difference in
the magnitude of the rate increase of only 25 basis points in Australia,
relative to its impact on global currencies, speaks volumes as to both the
heightened sensitivity and the fragility of currency levels.
The decline in the U.S. dollar
appeared to be a boon to U.S. multinationals, those with significant
international presence, lifting their stock prices. Large and mid-size
companies are becoming increasingly more dependent upon international
business activity. This not only provides a one-time boost for corporate
earnings but also suggests increasing competitiveness of U.S. products abroad
with potential for increasing market share. While the short-term benefits to
corporate profits may be positive, lifting the Dow over 10,000, this may be
exceeded by the long-term consequences of the loss of foreign capital as the
U.S. is perceived as a less stable location for foreign investment.
It would appear that foreign banks
have not yet lost their appetite for U.S. Treasury securities. Over the
five weeks leading up to the week ending October 7, 2009, foreign central
banks purchased $48.55 billion in Treasury securities, an average of $9.71
billion per week. Interestingly, during the same period, the dollar
fell more than 3% on a trade-weighted basis against its six primary
rivals. Currently, the total amount of U.S. Treasury securities held by
the Fed on behalf of foreign central banks has increased to a record of $2.098
trillion, up from $1.528 trillion a year ago. While foreign central banks
buying U.S. Treasury securities is positive, compensating for lack of
domestic demand, any decline in demand or the trend for increasing U.S.
deficits may drive the U.S. dollar even lower, or force an interest rate
increase. The Fed’s low interest rate policy in the U.S. may lead to
additional declines in the U.S. dollar, signaling inflation and potentially
higher gold prices.
Fed Appears Unlikely to Raise
Interest Rates Anytime Soon
It would seem reasonable with the
increase in reserves that the Fed would be more cautious in its statements to
“sterilize” speculation on both a weaker dollar and
inflation. Comments by Fed presidents in the financial media suggest
that they have no plan to raise interest rates to reduce quantitative easing
anytime soon. Federal Reserve Vice Chairman Donald Kohn said interest rates
could stay low for a long time, and that a recovery with sluggish growth
should keep inflation under control. From the Fed’s perspective,
only easy money will stimulate the economy, and this being their primary tool
to achieve their mission of full employment, shows little compulsion to
reverse direction and increase interest rates.
Kohn does not “think a
V-shaped recovery is the most likely outcome this time around… and that
the recovery in the U.S. economic activity will proceed at a moderate pace in
the second half of this year before strengthening in 2010.” He
concludes optimistically that “the persistence of economic slack, accompanied
by stable longer-term inflation expectations, will keep inflation subdued for
some time.” This refers to “the substantial rise in unemployment
rate and the plunge in capacity utilization” which he views as
“considerable.” From his perspective, long-term inflation
expectations remain stable, and inflation itself could move
“appreciative lower” with low interest rates for an
“extended period.” In addition, Richard Fisher, president of the
Dallas Fed believes that no one at the Fed thinks this is the time to raise
interest rates.
The Fed appears to be fixated on
reported U.S. inflation and unemployment as opposed to global indicators such
as the price of gold and the falling exchange rate for the U.S. dollar. This
caused a minor eruption when it was rumored that some countries were
interested in moving away from pricing oil in dollars. This may significantly
reduce demand for the U.S. dollar relative to other currencies. The rumor of
moving away from the U.S. dollar was rapidly dispatched by the related
central banks and declared “absolutely not true.” Kuwait
Finance Minister Mustapha al-Shamali said the dollar would remain the
currency of oil trading because there is “no problem using it.
The European Central Bank (ECB)
President Jean-Claude Trichet said excessive volatility in currency markets
is the “enemy” of stable economic activity. While the ECB has
confidence that the U.S. is pursuing a policy to strengthen the dollar, other
than foreign bank purchases, little other evidence for this initiative is
readily apparent. Should the U.S. dollar continue to show systematic signs of
weakness, it would be prudent for other central banks to seek to attach to a
more stable global currency for international transactions. Interestingly,
the ECB president hoped to see a more-flexible yuan exchange rate, providing
insight to where he perceives stability.
Not Worth a Continental or Not
Worth a Bernanke (or Geithner; take your pick)
The current U.S. Administration
may have more in common with its Founding Fathers than they would like to
admit. In order to finance the current U.S. Administration’s
revolutionary new “Era of Responsibility,” the phrase “not
worth a Continental” may be coming back into fashion. Despite
politicization of economic reports, TARP and the Federal Stimulus Program may
have succeeded in averting a meltdown of the economy, but arguably may have
come up short for either increasing supply and demand for credit, stimulating
real economic growth, or reducing unemployment as advertised.
The U.S. Administration’s
ability to forecast the economy is arguably suspect.
They estimated that the $780 million stimulus bill would keep unemployment
under 8%. This rate is currently 9.8% and is expected to exceed 10% in
2010. Now, their projected budget numbers estimate a trend of deficit
spending increasing the federal debt. They forecast a drop in the current
deficit to GDP of 9.9% to average 4.8% from 2010 to 2114 and 4% for the years
2015 to 2018. This would increase the federal debt to $23.3 trillion by 2019,
from about $11.9 trillion today. These forecasts were prior to any additional
stimulus programs or exogenous setbacks. The record of their forecasting
models to date suggests that these forecasts should undergo additional
scrutiny.
The federal debt was 61.4% of GDP
in 2008. It is anticipated to climb to 90.4% in 2009 before reaching
100% in 2011 and remaining over this level through the ten-year forecast
period. In 2008, the U.S. ranked 23rd for debt-to-GDP, and when it exceeds
100% it will advance to seventh place (behind the likes of Zimbabwe, Japan,
Lebanon, Singapore and Italy). Interestingly, at the current level, the U.S.
would not be admitted to join the European Union, which requires that
participating governments limit debt to 60% of GDP.
The Japanese experience of
quantitative easing following their bubble in the 1980s presents a cautionary
tale. Debt-to-GDP in Japan increased to 170%, followed by decades of
economic stagnation before descending to the current level. During this
period, the yen declined from 10.2% of foreign exchange reserves to 3.3%
today. By comparison, the U.S. Dollar presently is the most common
currency for international transactions, constituting over 60% of other
country’s official foreign exchange reserves.
The United Kingdom May Provide a
Peek at the Future U.S. Economy
The challenges faced by the UK are
similar to those faced by the U.S. The UK economy is weak with declining
industrial production, a condition that is expected to last for years. The
Bank of England (BOE) has responded with its own stimulus program and low
interest rates. Inflation is expected to exceed the BOE forecast for
inflation of 2% and 3.4% for 2009 and 2010, respectively.
Issuance of government bonds in
2008-2010 is expected to be greater than the prior ten years combined. The UK
budget deficit is expected to reach 12% to 13% of GDP, with debt-to-GDP
growing to 80% to 90% of GDP by 2015, nearly twice of what it was before the
economic downturn, and putting its credit rating at risk. As about 30% of
bonds issued are expected to be taken by foreign investors, should investors
not materialize for future bond sales, the UK could be significantly
challenged.
Concern over fiscal policy in the
UK that is leading to sustained high deficits and challenging the
independence of the BOE have led investors to swap out of the sterling for
potentially higher-yielding commodity-backed currencies with better
fundamentals. This has led to a similar situation with the U.S. dollar,
where the pound is being borrowed and sold to acquire currencies with higher
interest rates and better prospects. In the third quarter of 2009, the
pound sterling and the U.S. dollar lost 2.3% and 6.9%, respectively, against
the euro.
The pound sterling appears to be
more vulnerable to devaluation than the U.S. dollar. It is important for
other nation’s central banks to support the U.S., at least temporarily.
Should central banks follow Australia’s lead, both the pound sterling
and the U.S. dollar will come under pressure. South Korea may be the next to
raise interest rates, perhaps before the end of the year. Other likely
candidates for increasing interest rates include Israel, Indonesia, Taiwan,
India and China. Any of these countries raising rates will absorb global
liquidity, thereby reducing the attractiveness of other currencies. That will
make it progressively more difficult for the UK to attract foreign investors
without increasing interest rates or significant devaluing. From the
perspective of an investor in the UK, gold and gold equities will become more
attractive. This may provide U.S. investors a peephole into their future, and
provide a template for investment in gold and gold equities from the U.S.
perspective.
Prescription for a Sick Economy:
Take Your Medicine
The case for gold from a U.S.
perspective may have never been better only because the U.S. dollar has never
looked worse. Clearly the dire circumstances suggested by the Japanese
experience since the 1980s can be avoided, but this requires leadership,
political will and optimism for a brighter tomorrow that is sadly absent from
public discourse in the U.S.
The easy path for politicians,
academics, and bankers forms the consensus which favors careerism and
personal advancement rather than the hard choices which foster an environment
for economic growth. This hard path of sacrifice requires a change in
mindset, favoring free markets, rule of law, and stable money. This new path
would also pursue constructive resource and energy development. While this is
contrary to the preservation of political power and other non-market and
obstructive agendas, gold remains the best means to preserve wealth from a
U.S. perspective given the prospect of further devaluation of the U.S. dollar
and stagnant economic growth.
Mike Niehuser
Beacon Rock Research.com
Also
by Mike Niehuser
Mike Niehuser is the founder of Beacon Rock Research, LLC
which produces research for an institutional audience and focuses on
precious, base and industrial metals, and substitutes, oil and gas,
alternative energy, as well as communications and human resources. Mr. Niehuser was nominated to BrainstormNW
magazine's list of the region's top financial professionals in 2007.
Mr. Niehuser was previously a senior equity
analyst with the Robins Group where he was a generalist and focused on
special situations. Previously he was an equity analyst with The RedChip Review where he initially followed bank stocks
but expanded to a diverse industry range from heavy industry to Internet and
technology companies.
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