Forex is exciting - but gold is still more attractive

As oil exporters move towards abandoning the dollar peg and China is increasingly concerned about managing its dollar reserves, get ready for some pretty big developments.

The currency sector has become ever more important and as we have said in previous issues, we expect major investment opportunities to occur.

The UK's currency, although less vulnerable than the US dollar, is nonetheless a candidate for weakness.

The pound is likely to fall as the UK's financial sector continues to deteriorate as it certainly will.

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Our faith in the gold bull market is based partly on our long standing view that the US dollar is set to further weaken very considerably. From a purely technical point of view, the Dollar Index has now broken below its level of resistance from 1992. In the previous issue we quoted W D Gann's comments about how such an event, and the action thereafter, is likely to be very dramatic.

General de Gaulle said at another time of dollar weakness. "The dollar is America's exorbitant privilege." What he meant was quite simple, America is the world's reserve currency and the currency for international trade.

If a country like Argentina builds a significant current account deficit, that deficit is dollar denominated whilst their currency is the peso. It's just a matter of time before the peso collapses and the country is bankrupt. America is fortunate that their deficit is denominated in their own currency, which means they can just print more paper money. They have taken advantage of that privilege and behaved imprudently, not caring about the deficit because of the lack of risk it posed to them.

Oil producers and exporters such as China have chosen to manage their currencies to stay in line with the dollar and pile up their foreign exchange surpluses, in dollar denominated assets, particularly US government bonds. This process means inflating their own money supply.

Inflation in these countries has now become a serious issue and more likely than not will only be remedied by allowing their currencies to rise against the dollar to a more appropriate level.

Speculation that the Gulf States might abandon their pegs was further fuelled by Sultan Nasser Al-Suwaidi, United Arab Emirates' Central Bank Governor, and he said that the dollar slide has pushed the country to a crossroad over its dollar peg and that there were strong social and economic pressures to drop the peg.

The same situation applies throughout the Gulf with only, it seems, Saudi Arabia standing up and supporting the peg although even they might have to reset it at a higher level.

According to Wen Jiabao, the Chinese Premier, China is genuinely alarmed at the falling dollar saying it is increasingly difficult to manage their $1,430 billion reserves. Value he said is under unprecedented pressure. Chinese inflation which, even after five interest rates rises this year, is still rising, is officially at 6.5% whilst food prices are rising at 17% per annum; that, to some extent, is a global story, core inflation rates lowish but food and energy inflation rocketing.

A number of hedge funds are betting on the situation, taking positions in Gulf State currencies so as to benefit from the end of their dollar pegs. They really expect something to happen, as surely it must, because the artificiality of pegged currencies always fails to sustain, it's when, not if! According to the dollar chart, the dam has burst so the action could get fast and furious soon.

What action should we take? Undoubtedly, exposure to gold related investments makes tremendous sense particularly because, the dollar is likely to fall considerably and gold is inversely correlated with the dollar. If you were diversifying dollar denominated foreign exchange reserves, wouldn't you put some of that money, indeed quite a lot of that money, into gold bullion we certainly would.

By John Robson & Andrew Selsby at fullCircle Asset Management (formerly RH Asset Management Limited), as published in the threesixty Newsletter (formerly the Onassis newsletter), a fortnightly newsletter that gives insight into the investment markets.

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