Gold is up $40 an ounce (6.6%) since November 1st and rose $7.38 an ounce just in the last week alone. Since November 1st the Dollar has fallen 4.60% against the Euro, 3.99% against the Pound and 1.71% against the Yen, so it should therefore not come as any surprise to anyone that gold is up in US Dollars. My long-term thesis is that the gold price will rise by about 50% from its current level as the Dollar loses roughly 35% of its exchange rate value.
In more recent commentaries I have also mentioned that I thought base metal prices were way too high, and that a decline in base metals due to falling demand from a slowing US economy (that will impact European, Japanese and Chinese economic growth as well) is the biggest risk to gold that I can see. Were it not for sky-high base metals prices I would once again be essentially 100% invested in gold right now. The risk is that if base metal demand softens, investment funds that had bought base metals as a hedge against the dollar may start selling all their metal holdings, including gold. Of course, I don't know that it will happen, but I do think it's a risk.
Will base metals prices collapse?
The key question, therefore, is whether the dollar will fall fast enough to prevent a collapse in base metals prices, or whether base metals prices will fall before the dollar takes another tumble. Up until two weeks ago I would have bet on the latter; however, given the trouncing that the dollar took last week I am not so sure any more. Fortunately, in accordance with the Better Sleep Principle, I have enough gold investments that I would be really happy to see the gold price rise and enough cash that I would be equally happy to see it fall.
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While reading through some of the data and news reports from the past week I again came back to a thesis I postulated some time ago: that we are going to see the dollar fall in conjunction with rising US interest rates. I know it makes no sense at first blush, but I also find it hard to see how things could play out any differently.
Take the US stock and bond markets for example: The S&P500 Index is up 11.9% since the beginning of the year. That sounds pretty good. But if you were an international pension fund in Europe you would have made a paltry 0.78% return on your investment because the dollar is down 11.12% against the euro this year. A London-based fund would have lost 0.97% on its US equity investments if it could match the performance of the S&P500.
During the year the US Dollar lost 11.12% against the Euro, 9.09% against the Swiss Franc and 12.87% against the Pound. How long will it be before international bond and equity funds decide to cut their losses?
What will dollars falls mean for bonds and equities?
US 10-year Treasury Notes declined during the first half of the year and rallied during the second half, but today are almost exactly where they were in January. So if an international pension, hedge or bond fund, or any other international investor, held US Treasuries they would have lost approximately as much as the dollar declined against their respective currencies, which in some cases are double-digit losses. The Organization for Economic Co-operation and Development (OECD) was quoted in Forbes earlier this year as saying the dollar had to fall by 35% to 50% in order to balance the US current account gap. My calculations indicate the dollar has to fall by about 35% based on what I think the gold price should be. The US' largest trade deficits are with China and Japan, and against their two currencies the Dollar lost only 2.94% and 1.84% respectively this year, which means there is a lot more downside ahead. When the Asian shoe drops it's going to be a whole other ball game.
At the moment 43% of all US Treasuries held by the public are owned by non-US residents. Do you think those investors are happy with the decline in the US Dollar? The current yield on a 10-year Treasury is 4.4%, which means that most European bond investors that held US Treasuries lost money this year. When they do the rational thing and sell their US notes and bonds, US interest rates will start rising. But because this will coincide with selling dollars and buying other currencies such as Pounds, Francs or Euros, the Dollar will fall at the same time as interest rates are rising.
There is very little the Fed, or anyone else, can do about this. About the only thing the Fed can do is to monetize the Federal debt (buy US Treasuries in the open market). The problem with monetizing the debt is that the Fed has to create brand new money to pay for the bonds it buys and by doing so it will increase the US money supply, which will cause prices to rise and the dollar to fall even further (could this be why the Fed decided to stop publishing M3 data and why Ben Bernanke is so worried about inflation?).
I have a dozen articles on my desk about the housing market, the auto industry, jobs, interest rates, the retail sector and so on, and I considered writing about the sad state of the US economy again this week, but I think it is much more important to keep our focus on the bigger picture. I suspect very few people anticipate that the dollar will fall while US interest rates rise, and I cannot be sure that it will actually play out that way, but stranger things have happened.
I do know that we are living in uncertain times and that even though history repeats, it never repeats exactly. I can only reiterate what I said earlier: Were it not for sky-high base metals prices I would once again be essentially 100% invested in gold right now.
First published on Kitco.com (www.kitco.com)
By Paul van Eeden
Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com). If you would like to read more from Paul, you can sign up to get his weekly commentary at https://www.paulvaneeden.com/commentary.php.
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