Strange Brew … What the Dollar and Gold Are Telling Us

A month or two ago, I promised I would pen a report that would answer the most-asked questions I've been getting at client events and through other channels.

Interestingly, they have a dominant theme: all tied to the weakness in the dollar, the strength in gold, rising government debt—and what they all say (or don't say) about inflation. Today's report dives into these subjects again. It's longer than usual, so bear with us.

The heightened media attention on the dollar's 14-month low (against a basket of six major currencies) is a key culprit behind the rash of questions we've been getting.

There's no greater example of a story that has captured investors' attention than the one in a British newspaper that claimed Arab oil sheiks were conspiring with Russia and China to cease using the dollar to set the value of oil.

It was immediately denied by everyone ostensibly involved, from the head of the Saudi central bank to US, Chinese and Russian officials.

In fact, the story seemed odd from the get-go in that it was only vaguely sourced, included only one quote from an unnamed source, and didn't name any officials who had allegedly participated in the secret meetings. It also didn't mention anything about the meeting's location or date(s).

The only "detail" in the story was the year 2018, which was alleged to be the year by which oil would no longer be denominated in US dollars. It was ultimately discovered that the author has historically been associated with very radical theories, which has served to squash the credibility of the story, at least for now.

The problem, of course, is that the dollar's downward momentum was only exacerbated by the rumor and serves to highlight not only the global mood of concern about America's currency, but also today's era of fast-moving information flow and loads of money-chasing momentum (the real culprit behind the dollar's weakness and gold's strength in our opinion).

This new downside momentum for the dollar comes on the heels of a period from late last year into early this year when the dollar benefitted greatly from a flight to the relative safety of US Treasuries and other dollar assets.

In the heat of the crisis, the dollar was seen as less risky than other investments. But we believe the key to renewed weakness is the massive ebbing of global risk aversion since the crisis' heyday.

The bottom line: The risk calculus has reversed and nondollar investments have been much more rewarding while holding the dollar has become a performance drag.

The weak dollar is seen as a virtue to some—and it's assumed that's the view of the Obama administration and its Treasury Department.

The current administration (and the two that preceded it) publicly suggests it favors a strong dollar, but all indications are that it's willing to quietly tolerate its fall, if not cheer it.

The pro-dollar weakness case rests on the aid it provides to US exports, the trade deficit and related manufacturing job growth. It could also help achieve the long-sought rebalancing of the global economy—with the United States exporting more and others (notably China) importing more.

Unless the dollar's weakness turns into a confidence-shattering crash (oft-predicted but not a view we hold), it's likely the key players will continue down this quiet path of tolerance.

Regardless of the short-term benefits that accrue from a weaker dollar, we mustn't forget the perils of a weak currency in the long-term.

Chuck and I both mentioned this at the recent Talk to Chuck Town Hall, referencing an op-ed in The Wall Street Journal by economist David Malpass—someone I know and for whom I have great respect.

His argument is that capital flows dwarf trade flows as a source of wealth creation. The only way to build wealth and create more high-paying jobs over time is through the productivity gains that come from greater investment and innovation.

As the dollar falls and capital flees the United States for other countries, those global competitors reap its benefits and become more productive and relatively more prosperous. That is the most significant problem a weaker dollar brings in the long-term.

We share these concerns, as well as those about our burgeoning public sector deficit. History shows we can run lofty deficits for some time before the cart tips. But the markets' and investors' tolerance won't last forever.

If the bond market specifically, and investors generally, see a credible deficit-reduction plan that's aided by strong economic growth, a dollar crisis can likely be avoided. However, without that plan, the doomsayers could be proven right.

Shorter-term, we come down on the side of the debate that the recent weakening of the dollar is a sign that markets are normalizing after the flight-to-safety trade that dominated the crisis period.

The dollar has also found a new role as the funding currency in the "carry trade," whereby investors borrow in low-rate dollars, subsequently selling them to invest in higher-return investments elsewhere. It appears to have overtaken the Japanese yen's prior role in this trade.

As long as the dollar's secular (longer-term) decline remains contained and steady, there are positive aspects to a path toward multiple reserve currencies versus the dollar as the sole monetary standard.

The role of the dollar as the dominant international currency drove the United States' large trade and current account deficits, which have only recently begun to improve.

In fact, the huge related inflows of foreign capital turned out to be a primary cause of the recent financial crisis as they contributed to low interest rates, loose monetary policy and excessive liquidity (not to mention the role of questionable regulatory oversight). These conspired to cause investors to ramp up leverage and vastly under-price risk … and we know where that led us.

Indeed, a sudden halt by our creditors to support our debt (unlikely, as it would be aiming the gun squarely at their own economic feet) would weaken the dollar further, push rates and inflation higher, and weaken the economy yet again. But a sudden halt is not in the cards.

According to the International Monetary Fund (IMF), today, about 65% of the world's reserves are in dollars and about 25% are in euros. In the early part of this decade, the dollar represented more than 70% while the euro was less than 20%.

There is a diversification shift under way and it has accelerated recently, but it's generally occurring slowly. Ultimately, it's a proper shift: A global monetary system that rests on a single country's currency is not ideal. We have started down that path.

For those who fear a Chinese retreat from the dollar, note that the country has actually increased its dollar holdings—buying up more dollars (and more Treasury bonds), thus preventing its currency from rising and so keeping its export industries humming even in the face of the weakened US economy.

This might change, but a crisis is unlikely until China becomes less dependent on its exports to the United States. It will likely play out over a period of years (not months), and will depend on both economic and cultural changes that will allow their savings-obsessed consumers to become greater global consumers.

We know it's equally problematic if foreign investors do finance our debt for an extended period. This might be why there's growing tolerance for a less prominent role for the US dollar in the global economy.

Many now believe that the huge capital flows that necessarily accompany deficits and currency dominance might no longer be in our country's best interest. This is the view of Fred Bergsten, former assistant secretary of the Treasury for International Affairs, and it's gathering adherents. (Read Bergsten's "The Dollar and the Deficits: How Washington Can Prevent the Next Crisis" article for more.)

There's a growing concern about a major inflationary threat posed by our burgeoning deficit, very easy monetary accommodation, and the weakening dollar—further highlighted by the sharp rally in the price of gold.

We remain in the camp that there's no imminent price inflation risk on the horizon, largely thanks to the pressure that remains on wages and unit labor costs (due to weak labor demand), a historically low capacity utilization rate, diminutive lending by financial institutions, and benign market-based indications of inflation risk. Treasury Inflation-Protected Securities (TIPS) are telling us inflation will be under 2% for the next 10 years.

Many folks with whom I've spoken assume that the budding economic recovery is also inherently inflationary. This is not the case , as the chart below shows. Historically, inflation tends to fall for a full year after recessions have ended.

Another sign that inflation risk is low, presently, is the velocity of money argument—one we've used a lot to express our views.

Indeed, money creation has surged during the past year, but there are no signs of inflation … meaning a lot of this excess money is going to shore up banks' capital bases and/or fuel asset price inflation (gold, stocks, etc.).

Velocity of money is also referred to as the money multiplier, which I explained in detail in an earlier report this year on inflation vs. deflation. Mathematically, the money multiplier equals M2 money supply divided by the monetary base. Generically, it's the amount of money getting from the banking system into the economy.

We can keep putting gas in the tank, but if there's a leak in the bottom, it won't help the car run. Our bottom line remains that inflation is not a near-term risk, although it remains a longer-term concern if deficits aren't reined in.

Finally, many are pointing to gold trading at more than $1,057 an ounce as a harbinger of inflation.

Gold bulls abound! (Where were they all four years ago when gold was half its current price?) In contrast to conventional wisdom, gold is a dubious indicator of inflation. Historically, gold prices have risen in both inflationary and deflationary periods as highlighted in a recent report by BCA Research.

The first gold bull market was in the mid-1930s, when gold was revalued upward by 70%. This was a highly deflationary period.

The second gold bull market started in 1971, when the dollar was de-pegged to gold, causing gold prices to soar. This was an inflationary period.

The third gold bull market started in 2001 and has so far lasted for nine years. During this period, the world economy has been confronted with periodic deflation threats, first with the tech bubble bust and more recently with the financial crisis and attending recession.

The only factor that can consistently explain gold price moves is the speed of fiat money creation. Dollar-based liquidity, a measure of global money creation, has had a strong influence on the direction of gold prices since the 1980s. As BCA notes, if money creation cannot lift general inflation, excess money must find its way to asset markets, lifting asset prices. Bingo.

Recently, gold has represented a proxy for risk. If you're jumping on the gold bandwagon, be mindful of the possibility that gold could turn negative once (if?) the world economy has rebounded strongly and central banks are ready to tighten monetary policy.

Like the rebound in global stock markets, the adjustment to massive global monetary stimulus has been quick and sharp, but maintaining this rate of change is likely unsustainable. It's likely that the stock market and the dollar take a breather at some point (with stocks correcting and the dollar finding a bid).

The move in the dollar in particular has taken on momentum-type characteristics and is a "crowded trade," with overwhelmingly bearish sentiment (a contrarian indicator). As we saw with crude oil in 2008 (and as we warned then), these types of moves tend to overshoot and then reset.

Factors that could provide a short-term countertrend lift to the dollar include:

* Moves by foreign governments to weaken their currencies in an effort to boost their own exports.

* Any change in expectations for Federal Reserve policy that would imply a sooner-than-expected rate hike (something about which we've been warning).

* Any change in posturing by the Obama administration with regard to dollar policy could give a boost to the currency.

There has been a dramatic rise in the amount of capital moving in the world—all of it in search of the highest returns. The dollar, gold, equities (domestic and emerging market), and US Treasuries are all partaking of the same surge in global liquidity.

Investors of every ilk have a tendency to focus on short-term gains over long-term discipline. And, of course, information flow is instantaneous today, fueling not only a herd mentality, but establishing the preconditions for the era of bubbles in which we reside presently. Beware of the herd.

Good article. It will take a while for the USD to be unseated as the reserve currency.

But if the printing of money continues, we eessentially will loose reserve status, and America’s standard of living will fall dramatically.It is already lower than Japan’s.

However, after we get rid of our national socialist radical malaise, we can claw our way back, after blowing the cordite smoke out of our rifle barrels, IMHO.

3 posted on 10/23/2009 2:55:10 PM PDT by Candor7 (The effective weapons against Fascism are ridicule, derision, and truth (Member NRA)

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