U.S. Dollar Strength and Implications for Gold

January 22, 2009

Continued Artificial USD Strength

Human beings have the bad habit of valuing things on a relative basis. Absolute value is very hard to comprehend. The recent USD strength has been a factor of weakness in foreign currencies and NOT strong fundamentals for the USD. This was highlighted Tuesday when both Gold and the USD rallied on the back of Euro weakness. Allow me to highlight several fundamentals that are developing:

1) The Euro is being tested. The idea of a unified currency has always troubled me, it seemed to be more of an experiment than a logical conclusion. To be more specific, it is not the idea of a unified currency that is troubling, but rather the idea that countries with independent fiscal policies are all tied to the same monetary system. It was only a matter of time until disparities emerged in the various member countries with respect to inflation expectations and output trends. The unified currency reduces options for struggling economies who are forced to stimulate ONLY through the fiscal approach. That means that deficits balloon, but with a 3% of GDP limit imposed on member nations, fighting between members may quickly emerge. With more than €1 trillion in Euro-zone debt issuance expected this year, the EU is not far off from the numbers being reported out of the U.S.

2) Exporting nations currencies are feeling the pinch. This was highlighted by Gregory Weldon of Weldon Financial in a report out Tuesday. He specifically mentioned the bearish outlook for the following export reliant currencies: Korean Won, Indian Rupee, Polish Zloty, Hungarian Forint, Czech Koruna, Canadian Dollar, Chilean Peso, and the Mexican Peso. The trend over the past few years has been for the U.S to import an ever increasing dollar amount of goods and services. That resulted in selling pressure on dollars and buying pressure on exporting currencies to purchase the local goods for export. With the sharp decrease in U.S imports over the past few months, export reliant currencies have felt the sharp decrease in demand. Added to that pressure, the sharp drop in the price of crude has led to a double hit on currencies such as the Canadian dollar.

Is pressure easing on these export nations? It doesn't look like it. In fact, if we use the Baltic Dry Index as a leading indicator of global trade, the outlook is pretty dire. Consider that this Index was sitting higher than 11000 less than a year ago. Although the index appears to be stabilizing, global shipping prices are still extremely cheap, highlighting the lack of demand.

That lack of demand will likely keep U.S dollars at home and in many cases, those dollars will end up getting tied up in treasuries. As U.S consumption falls to below normal levels (normal by global standards, obviously far below U.S standards), the rate of savings in the U.S should rise as long as unemployment is kept under control. This doesn't appear to be a trend that will reverse any time soon and will likely continue to hurt export reliant countries.

Then there is of course the thousand pound gorilla in the room - that being competitive currency devaluation. This will be predominant in the exporting nations who are fooling themselves that they can increase exports by making their currency weaker, ignoring the global trend of trade deflation.

3) In comparison to, well, every other central bank in the world, the Fed is far more scrutinized. This makes currency devaluation harder and shifts the risks of currency debasement to global nations. This obviously supports the U.S dollar on a relative basis. Even other sovereign nations would rather print money and shift the funds into USD as they seek the safety and stability of the US. That being said, the USD is in and of itself weakening in my opinion - but strengthening against almost every other asset. Quite a dilemma for a trader. At some point, the Fed may be able to justify currency devaluation if everyone else is doing it. It's not a good argument, but it's an easy sell to Capitol Hill where they can easily argue that their exporters cannot compete with such a strong dollar.

Gold

I remain perplexed with regards to gold prices. On a valuation basis and discounting what the market KNOWS the Fed is doing, gold is overvalued in my opinion. That being said, all of the fundamentals of what is currently occurring points to a higher gold price in the future. I am not going to delve into why gold should rise in these times, as most of my readers are very aware of why gold strengthens when fiat money weakens. Rather, I will continue (as I did most of last year), to encourage discussions of why gold won't rise this year. It is only when there is an understanding and respect of both arguments that a rational decision can be made.

While most media highlighted that gold failed to perform last year, with many expecting $1200+ by year end, I view it differently. I see gold as performing excessively well. With asset prices tumbling, energy prices imploding, consumer credit drying up and consumer prices disinflating, gold's performance was actually quite remarkable. As a supposed store of value, gold's purchasing power over almost everything increased quite dramatically. Why?

The gold market, like all markets, is a discounting mechanism. Currently the gold market is pricing in that the Fed will stop at nothing to try to reflate the equity and real estate markets. Thus, the gold price is holding at levels where it was when real estate, energy and equities were significantly higher. I think the Fed will fail and thus a lower gold price is justified. Why will the Fed fail?

Nouriel Roubini's new estimates are that US institutions will see $3.6 trillion in credit related losses. Considering that the banking system started with $1.4 trillion in assets, this makes the US banking system effectively insolvent (source).

Then there are the secondary economic effects after these bank losses such as lost output and lower domestic demand. Higher unemployment is an added burden on the state. Although the numbers out of the Fed such as the growth in their balance sheet and the estimated $2 trillion+ of Treasury debt sounds ridiculously large, it is dwarfed by the actual losses we are seeing in the system.

Thus, a lot of this money being pumped in will (1) maintain the system at a unproductive level through higher unemployment costs and (2) barely fill the gap that these losses are mounting to.

Then there's another question: Is pumping this money in the equivalent of filling a pothole or is the analogy better suited to a black hole? If these institutions aren't allowed to fail, I fear that losses could mount in excess of even Roubini's estimates as the state continues to pay off losses that would otherwise be cancelled through the bankruptcy process. These losses include money thrown at the non-banking sector as well.

Gold price maintained value over the past decade by increasing to reflect what appeared to be increasing wealth of the global citizenry. Turns out it wasn't real wealth but rather inflated through irrational exuberance of the price people were willing to pay for real estate and the volume of consumer goods they were consuming. Bargaining power has shift from suppliers to consumers, unemployment is rising and asset prices are tumbling.

Gold remains high on the idea that the Fed will reflate. They have exhausted their first tool (interest rates) and are now focusing on other methods. Fiscal stimulus has its limits as the question still remains as to who will buy all of this government debt - not just the U.S, but every sovereign nation who is issuing record amounts of debt. The Fed could print to buy government debt, which surely will be a major theme this year, but it has its limits as well. As much as the Fed wants to stabilize asset prices, I believe that they are conscious of going too far and the destructive consequences of creating high inflation when unemployment is making new highs as well.

The Fed will eventually run out of ammo unless the rest of the world inflates and hands that money over to the U.S treasury to be returned 30 years later. In that scenario, the dollar could strengthen this year as I have highlighted above.

Gold will undoubtedly make new highs this year, but it will likely occur in reference to foreign currencies which are tied to exporting economies - that is the safer bet.

Disclosure: no positions

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