Gold, Dollar and Fed

123jump.com Staff
23 Apr, 2006
Metals

Recent events in stock market suggest that interest rate hike may come to a stop and that will be good for the econony and by extension for stock market. It is widely believed that price inflation is under check and asset inflation is temporary. The Fed has broadcasted in recent days that higher rates may wait. It is this lost time in waiting, may limit the Fed from taking actions to save dollar from future attacks in the international markets. Will gold rise in the short term?

When will the U.S. dollar come under attack?
China, Japan, Hong Kong, Taiwan, Korea, Singapore and India are one of the largest holders of U.S. dollar. China and Japan will soon have to diversify their holdings. The current trade surplus enjoyed by Asian nations has increased their vulnerability to U.S. dollar price volatility. Total U.S. dollar reserve of these six nations is now approaching $3 trillion. With the holdings of Japan and China at $880 billion, Hong Kong, India, Taiwan and Singapore holding between $150 and $200 billion each. Middle Eastern countries have established a similar U.S. dollar reserve of more than $600 billion and Russia now holds $220 billion in its foreign currency and gold portfolio.

These Asian countries now hold total of more than 72% of $4.5 trillion of global dollar reserves. These numbers are estimates but are gathered from IMF and fifty largest local Central Bank statistical agencies this week.

On Friday, Russian Finance Minister Alexei Kudrin questioned the U.S. dollar’s status as “absolute” reserve at the Finance Minister’s meeting among G7 countries in Washington. He went on to add that considering the volatility in the U.S. dollar value and size of its trade deficit with its trading partners in the world, the U.S. dollar does not deserve such a status.

Since the beginning of the year 2006, yellow metal has gained close to 20% and in the last 52 weeks has added 46%. Market analysts are quick to predict gold’s climb to $700 in the coming months from a low of $230 just three years ago. Several factors are conspiring to convince traders that gold will continue to keep climbing. Central banks around the world need to diversify their foreign reserves holding. Sweden announced today that it has begun to diversify its holdings away from U.S. dollar. Sweden’s Central Bank reported that it has reduced its dollar holding to 20% from 37% and raised its holding in euro from 37% to 50%.

A month ago a similar announcement was made by the Head of Central Bank in U.A.E, rich Arab nation to diversify away from dollar. South Korean Central Bank made similar commitment to diversify its holding as well in February of last year. The total dollar amount at stake is small. UAE, Sweden and South Korea collectively plan to sell small amount of dollar but if other nations join the trend the situation can become precarious in a hurry.

Fed’s ability to support the U.S. dollar may be limited.
The U.S. dollar fell 30% among a basket of foreign currencies between 2002 and 2004 on wider trade deficit. The deficit since then has grown more. In the year 2005, annual trade deficit has grown to $725 billion and is likely to cross $900 billion this year, yet dollar rallied in the last eighteen months. Federal Reserve Bank has raised interest rates fifteen times in the last two years supporting the advance of dollar. Once interest rate charged by the Fed crosses 6.5%, the future of dollar may be uncertain. Then depreciation in dollar may accelerate at a rapid rate if large annual trade deficit persists. If current oil prices are maintained for the next eighteen months the U.S. dollar is certain to take a hit if the Fed fails to support dollar through rate hikes. Yes, international trade is less than 20% of the U.S. economic activity but U.S. needs the support of foreign investors to attract annual direct investments of $120 billion, a very substantial force in job creation. According to the U.S. Treasure Department, between 8% and 9% of long term securities are purchased by international investors. Foreign investors now invest to the tune of 12% of nation’s GDP. Foreign owned companies employ 5.1 million people, one in every 20 in labor force. America needs this stable source of capital to create jobs and access to technologies to create new products.

According to the latest IMF data the dollar forms more than 65% of total reserves among Central Bankers and euro constitutes 25%. According to World Gold Council 90% of gold consumption is driven by demand for jewelry and industrial needs and the rest is by the demand from investors. Recently demand from investors has jumped from historic annual average of 400 tons to 650 tons and is rising at rapid rate.

Is the last three years rise in gold price driven by investors’ appetite to hedge against the coming decline of dollar or is it driven by speculators desire to profit, remains to be seen. But the Fed has less room to maneuver and is losing its ability to hold a lid on interest rate. The recent one day rise of 200 points in Dow Jones this week was based on a perception that interest rates are not likely to go up in the near term, may be misplaced.

Stock market prefers lower rates.
The day the stock market rose 200 points was also marked by a sharp loss in the dollar and rise in gold, silver, copper and crude oil prices. We already had a preview of what is to come if the Fed stops raising rates in the near future. Interest rates have been raised fifteen times and dollar has gotten ample support from international investors. International investors have been pouring money in the U.S. financial and physical assets. One can only conjecture when dollar will suffer from investor’s confidence crisis. Such a crisis is not imminent and not likely to happen in the next six months. But with each passing day the value of dollar in the international market is surely to come under attack. Rising trade and budget deficits will only contribute to these anxieties.

Last U.S. trade surplus was in 1964.
One has to go back to the year 1964 when the U.S. enjoyed last annual trade surplus with the rest of the world. Since then Japan and now joined by China and Middle Eastern nations have enjoyed trade surplus with the U.S. It is a common misperception that the trade deficit does not matter. Widely held belief is that it is the value creation and earnings of companies that matter to stock market investors.

China may have rising trade surplus with the U.S. and the rest of the world but value creation is very little in China. Majority of value is created in the U.S. plants and factories and China adds very little in the value to the goods that are exported via China. China plays a role of final destination in the global assembly line. True. China did not play that role twenty years ago and recently it has managed to become the only alternative for many industries as country after country has lost out to China in providing that role. In fact along with the U.S., Taiwan, South Korea and increasingly Japan have used China as the final destination in global assembly line. China’s role in value creation is only expected to grow.

It is not possible to beat up your largest lender, China.
What happens if China continues to maintain $200 billion annual surplus, Japan has annual surplus of $120 billion and even if Middle East moderates its current annual trade surplus from $250 billion to $100 billion with the U.S. for the next ten years? That will be a total of $420 billion shipped abroad for ten years, adding up to $5 trillion dollars. Yes, that is with a capital T.

And as increasing amount of value creation occurs outside the U.S. then will it not be possible that better paying jobs will migrate to those regions as well. American companies will still make profits, those that can create value and sustain its creations. The U.S. Congress has acted in the past to stem the budget deficit but for the last five years, either the Congress is unwilling or unable to control deficit. If world brings back some of those dollars back to the U.S., which is the current policy, we are increasingly likely to work for companies owned by foreign nationals.

It is perverse to expect poor nations to lend to rich nations. It is not sustainable. Because credit needs of rich nations in general are so vast that it invariably turns poor nation poorer and rich nation bankrupt. China is playing a dual role in supplying credit and creating value in the global market place. This will continue and will not stop till China finds better use of those excess dollars. It is only a matter of time that Chinese government will wake up and find better use of these excess dollars.

The question is who will turn first? Is it the Congress that will mend its ways or is it China that will turn somewhere else. There is also no guarantee that China will not repeat mistakes of an earlier rising power, Japan. Rise and fall of Japan in the last twenty years is widely chronicled but may not be well understood. Rise of China in the last twenty years is based on providing labor to the world. Rise of Japan was based on manufacturing and then design success in the international marketplace. China has not reached to that level yet, but is expected to make a steady climb in the coming years and strengthen its currency along the way. Rise of Japan is understood but its fall is not, and may take us a long time to decipher the root causes.

Rise of China and Japan – two different paths.
Chinese currency may follow the course of Yen. Japan adjusted, its currency, Yen from more than 350 yen to a dollar to 120 yen to a dollar in the last thirty five years, nothing but a sixty-six percent depreciation of dollar against the Japanese Yen. It is a widely held misperception that the rising Chinese Yuan will solve the American export problem and will save the dollar from a future malaise. The Yuan can rise comfortably 100% in the next ten years, if China sustains the current economic growth, yet problems with American exports and dollar may not go away.

The dollar is not going to be saved by rising Chinese currency. If that was the case, rising Yen in the last thirty years would have solved that problem. The current problems in the auto industry, and at its once leading company General Motors, are just a reflection of a lag in the cause and effect in the international market order.

A scenario - Defenseless dollar and gold at $1,100.
I do not know when the dollar will come under attack. Will it be this year or in the next five years. Will it be when Fed loses its ability to raise interest rate to save economy from slowing down? Will it be when oil crosses $90 a barrel? But, one thing is clear.

If the dollar is under attack when oil is at elevated levels for a sustained period, the U.S. economy is slowing down, China finds better use of dollars then to lend to the U.S., and the Fed is still talking of low interest rate environment, dollar will certainly be defenseless. At that time we have to blame only ourselves.

If this scenario comes to life then gold will escalate and may spike to $1,100 or even higher but that will not be sustained. Gold may trade at an elevated level but will eventually scale back to lower levels in the range of $400 and $600 per ounce. The fate of gold is clear but that of dollar is not.

Fed may not be able to defend dollar if rates remain low for too long.
This is only a scenario but if the Congress and the Fed do not mend their ways then slow but steady pace of the dollar decline is unstoppable. Everyone is looking for a crisis but steady and painless drift of dollar may pose a greater danger.

It is argued that the U.S. has sustained trade deficit for forty years and still managed to raise living standards. That is true and false. Yes, we have created two million jobs every year for the last thirty five years. But we created same number of jobs when we had 220 million citizens, in the seventies and eighties, and now when we have 300 million in the year 2006. The share of less than $15 per hour job in the labor pool has grown when total number of jobs created has not. In fact, Wal-Mart claims to create 220,000 jobs a year in this country adding up to 10% of all jobs created.