It is going to happen any time now, or so I am told. Because of the massive amounts of money the Feds are injecting into the USA economy through Quantitative Easing, inflation is going to spike any day now, and the dollar is going to crash. And with that, gold will go to the moon.
Yet, that is not happening. It must be frustrating for gold investors. It is likely also puzzling to them. In this article I will try to explain why the U.S. dollar is not likely to crash anytime soon, and hopes of a gold spike in dollar-denominated terms are just that, hopes.
I had earlier written an article explaining why there is little inflation in the USA. It has to do with the dropping velocity of money. The money supply is indeed growing from QEternity, but the money is not exactly changing hands in transactions and chasing goods and services. Increased transactions is what drives inflation, so lower velocity of money leading to lower transactions is suppressing inflation, even in the face of rising money supply. For more details on the velocity of money and its impact on inflation, please read my article on why hyper-inflation is a myth.
But inflation is not the only thing that drives currencies. The U.S. dollar may still crash against other major currencies if the exchange rates are not aligned with the core value of the two currencies in question. One way to measure it is using Purchasing Power Parity.
Purchasing power parity (PPP) is an economic theory and a technique used to determine the relative value of currencies, estimating the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to (or on par with) each currency's purchasing power. It asks how much money would be needed to purchase the same goods and services in two countries, and uses that to calculate an implicit foreign exchange rate.
One whimsical, but popular way to measure PPP is the Big Mac Index from the Economist magazine.
The Big Mac index is The Economist's lighthearted analysis of foreign-exchange rates. Our basket contains only a Big Mac, and relies on the efforts of McDonald's to produce identical products from the same ingredients everywhere.
So, what is the latest Big Mac Index saying about the relative valuation of currencies?
So, what does this tell us? For the U.S. dollar to crash against another currency, the currency has to be undervalued with respect to the dollar. It would also help if the currency that the dollar would crash against is a major world currency, so that it can actually absorb all the dollar outflows. The natural candidates are the euro and the yen - any other currency is simply not in the same league as the dollar when it comes to market size and liquidity. Yet, as the Big Mac Index shows, the euro is already overvalued against the dollar, and while the yen is still a bit undervalued, it is unlikely that the Bank of Japan will let the yen rise, given that the country is betting on a weak yen to recover from its own recession.
Still, the Big Mac Index is not exactly what solid economic analysis is based on. What about the Organization for Economic Co-operation and Development (OECD) numbers?
This is how to interpret the above chart. A basket of goods and services costing $100 in the USA would cost about 15% more in France and 8% more in Germany, which means the euro needs to come down by 8-15% for Purchasing Power Parity to be reached. According to the above, all three, France, Germany, and Japan, have currencies that are overvalued with respect to the U.S. dollar. So, the euro and the yen should weaken against the dollar instead of the dollar crashing against either of the two.
Also, there is a real quantitative easing going on out there in all the major countries. All these countries are trying to work their way out of the global recession by increasing money supply. Rumor is that the G-7 nations are soon going to come out with a coordinated statement stating that all of the G-7 nations will start to pump money into their respective economies, and not cause respective currencies to crash against each other. Reports Marketwatch:
News reports on Monday said officials from the Group of Seven nations continue to weigh the possibility of issuing a statement aimed at averting a so-called currency war. A pair of officials from the Group of 20 told Reuters that a G-7 statement could be released ahead of the meeting of G20 finance ministers and central bankers in Moscow on Friday and Saturday.
Bottom line, chances are bleak that the dollar is going to crash anytime soon. This is not good news for gold bulls, of course, as inflation is not in the horizon either. What does this mean for your investment thesis for the rest of 2013, dear reader? Well, my projection for gold prices (GLD) in 2013 remains unchanged, that shorting gold -- especially via the miners (GDX, DUST, NUGT) -- remains the play for 2013. For more details, please check out my other article titled "How Best To Short Gold - Miners Or Metal?"
In the mean time, I have initiated a position in DUST. I think the miners are really setting up to be perma shorts with falling gold prices and rising mining costs. I am currently flat on this position, and I expect this to be a profitable position exceeding 20% returns. Of course, nothing is a guarantee, but the Government of India position on gold demand in India, the G-7 position on coordinated money supply increase, and the low likelihood of inflation in the USA gives me a good reason to believe that I will make money on this.
Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choices.
Disclosure: I am long DUST.