Resurgent Dollar Leaves Gold in the Dust

The unloved dollar has proven among the best performing assets over the past 12 months as the dollar index gained 26%, with 'safe haven' gold pretty much flat, having peaked 10% above current levels last April. The irony is that just about every goldbug was also a convinced dollar bear a year ago, and their emotionally charged analysis has proved utterly misconceived in a deleveraging global economy.

On July 27th last year, I wrote:

The Euro, Yen and Sterling all risk major fundamental downside over coming months as evidence mounts that their respective economies are sliding into recession; decoupling is dead. Meanwhile the US trade deficit is in rapid decline... the prospects of a sharp dollar rally in the next few months are high.

Currency analysis isn't that complicated; ultimately, it comes down to whether foreign demand for US assets exceeds US demand for foreign ones. Not only did it seen obvious that the world economy would 'recouple', but also that a bursting commodity bubble would prove dollar positive.

click to enlarge image

But beyond these supportive factors, it became clear in the Autumn market panic that the world was structurally short of dollars, from professional speculators to emerging market corporates and foreign commercial banks. Indeed, the huge natural short position built up in European bank loan books is detailed in a new BIS report available here.

Many observers forgot that the low-yielding dollar was a 'carry trade' funding currency for foreign investors almost as much as was the Yen in the boom years. Another factor was the fact that Americans were selling foreign financial assets faster than foreigners were selling American ones through 2008, as can be seen in the chart below. Additionally, there was a huge surge in safe haven buying of T-Bills in late 2008 by overseas investors. So where to now for the newly virile dollar? While capital flows globally are still contracting, the way in which they are doing so is still proving dollar positive. I think the impact of rising US savings (to maybe 8-10% by year-end) and its impact on funding both the trade and fiscal deficits, is key to the outlook.

Structural dollar bears always assumed that foreign buyers of US debt and other obligations would eventually become sated, and dump US assets triggering a crisis. That analysis missed the extent to which those same countries were dependent on the US consumer for their employment and GDP growth prospects in an unsustainable perpetual motion machine of capital flows. Ultimately, it was the collapse of the asset side of US consumer balance sheets, as real estate and then equities slumped, that forced a rapid deleveraging and a US savings ratio hitting a current 5% heading to 8% plus.

Consumption as a share of US GDP is set to tumble to below the long-term average to maybe 62-64%, leaving foreign merchandise exporters trapped in a round of competitive devaluation to maintain their share of a shrinking pool of demand. While a smaller US current account deficit is probably net dollar positive, it does hugely reduce the surplus dollar volume exporters like China have available to recycle into US Treasuries (China and Japan accounted for 65% of foreign buying of Treasuries in 2008). With a 12% of GDP US fiscal deficit forecast this year, even if all the new US private sector savings were directed into bonds would leave foreign official buyers to pick up at least $500-700bn just as their trade surpluses slump. That's a big ask.

Funding the deficit at anything like current yields will be the litmus test of the dollar's new strength. However, as the US economy is in fundamentally in far better shape that the hugely overleveraged and export dependent economies of the Eurozone and Asia who with the demise of the US consumer simply don't have a Plan B, I'd expect the dollar to remain the tallest pygmy among major currencies for the foreseeable future, but ultimately devalue against real assets as incipient inflationary pressures rise over the next 2-3years.

Disclosure: None

Comments

[Truefire:]

Lets see if I have this straight. You recognize that the US GDP is shrinking, hence less consumption of chinese imports, thereby shrinking their revenues leaving them with less cash to loan to the US.

The Fed & Treasury are cranking up the printing press & you are a dollar bull?

Curious!!

Mar 08 08:50 AM

[J. D. Swampfox:]

The writer says, "the dollar will remain the tallest pygmy" I am beginning to agree. It seems clear that interest rates in the US will rise with monetization (monetary inflation). But the argument that the dollar will fall has to be based on the idea that interest rates will be lower - relatively, compared to the rest of the world. So...who will be the worst monetizer? -the US or the rest of the world? Both sides can make a good case...

Mar 08 10:50 AM

[GMiki1:]

Gold has been left in the dust? It's entirely possible for gold and the dollar to both trade up.

Mar 08 11:30 AM

[Dave Wrixon:]

"as the US economy is in fundamentally in far better shape that the hugely overleveraged and export dependent economies of the Eurozone and Asia who with the demise of the US consumer simply don't have a Plan B"

If this premise is correct then you are undoubtedly right!

ROTFLMAO

Mar 08 11:42 AM

[Old European:]

Dust ? What dust ?
I've bought gold at different entry levels. The highest I paid for my bullion was 570 Euros. Today gold stands at 740 euros. That's a 29% raise (in just a little over 1 year), NOT TO MENTION the gold that I had bought previously at even lower levels. If you call that dust, bring along some more !!

Mar 08 12:17 PM

[Vuke:]

Right on. The higher dollar has allowed the buyer to accumulate cheaper gold. Future inflation will be the real payback for gold (and silver) investors.

>>expect the dollar to remain the tallest pygmy among major currencies for the foreseeable future, but ultimately devalue against real assets as incipient inflationary pressures rise over the next 2-3years.<<

Mar 08 01:15 PM

[marketman54:]

Truefire's comment pretty much says it all! But you will have to factor in all the new money that is printed and not backed up when no one will buy our treasuries. Add some Jimmy Carter hyper-inflation at some point and gold will soar.

Gold still smells good to me and should hit $1,500/ounce when inflation starts to kick in.

Mar 08 02:56 PM

[donzelion:]

"The writer says, "the dollar will remain the tallest pygmy" I am beginning to agree."

Truefire thinks the author is a dollar bull. I wouldn't think a term like "tallest pygmy" amounted to bullishness.

Swampfox asks what must be the 10 trillion dollar question: who will be the worst monetizer? My guess? The Eurozone is self-limiting; if they move too far with monetization, bye bye Euro. The US, on the other hand, has few other options, and more foreign held debt than anyone else. All that debt in Chinese and Middle Eastern hands...why not "stick it to 'em"? (I don't see Obama moving in that direction - but I do see a more desperate, populist successor doing it without much hesitation.)

Mar 08 03:05 PM

[BrunoT:]

This is like fleeing upstairs in a highrise fire rather than risking the heat by running downstairs to true safety. Yeah, you're safer NOW than on the burning floors, and you've avoided getting singed, but you're eventually going to die if they can't put the fire out, because you took the easy way out.

Far from putting out the fire, the govn't seems to be feedign it dollar bills by the Trillion.

Mar 08 03:35 PM

[Russell Ups...:]

All the central banks in the world have been on a currency printng spree- as one writer put it the dollar has been like the winner of a beauty contest in a leper colony. The US banks spread those fake AAA CDOs around the world, the 70 billion the government is putting into the housing market will do little to counter the trillions in real estate value that has been destroyed, and why should other countries continue to pile into T-bills with the 10 year paying under 3% after we just got done running this sub-prime mortgage backed securities Ponzi scheme on them?

Mar 08 03:39 PM

[BrunoT:]

On Aug 5, 2008 Sean Maher wrote:

"it's now a good bet that on a 12m view, inflation concerns will have abated, the dollar will be in a surprisingly strong uptrend, and US equities will be materially higher from here."

Beware of those dispensing readings of the future for money. They're not much more reliable than palm readers. And like psychics, they never seem as proud of crowing about their abject failures as they do about the twice a day the stuck clock is correct.

Does about half sound like being "materially higher" to you?

Mar 08 03:43 PM

[asleeper:]

"The irony is that just about every goldbug was also a convinced dollar bear a year ago, and their emotionally charged analysis has proved utterly misconceived in a deleveraging global economy."

HIndsight is always 20/20. If the author was aware in advance that the dollar might be the best investment possible from 10/08 to now, was he advocating dumping all stocks and commodities at the time? I did, even my gold and silver ETFs.

In reality, just about about every goldbug knows that precious metals are volitile, and the "structural" matters in the market that lead to volatility are difficult to understand.

That is why even goldbugs pay particular attention to events that do not fit their conception of where markets and gold price are going. Practically every goldbug I now was all over the structural "deleveraging" idea in short order as the market crashed, gold went down, and the dollar rallied. This is NOT new news.

As a consequence, I got out of gold and silver very quickly, caught the first first bounce and recovered my initial loss, got out again, and waited for the carnage to end.

This business of knocking goldbugs cracks me up. They are like the stock pusher's bogeyman who cannot be mocked enough. Take it all with a grain of salt folks. The person you want to pay attention to is the person who KNOWS what is coming next. Good luck finding him.

Mar 08 04:59 PM

[dawase@gmai...:]

I've traded in and out of GLD and SLV fairly well this year and last, chalking up decent gains on every trade. I'm a little suspect of the hyperinflation argument but I've started accumulating physical as a hedge against currency volatility. I'd love to see gold and silver trade up 100-400% but I'm not holding my breath on that one.

The dollar is and will continue to be the reserve currency of choice for the near future. The situation is akin to MAD - Mutually Assured Destruction. Everyone holds US Treasuries and if anyone tries to dump, the resulting damage in price would be borne by them as much as the rest of the holders. The high-level negotiations going on now between China and the US surely revolve around how the US can bring the Chinese back into the US securities markets since they withdrew after being bit by the GSE debt debacle in 2008. While China needed a weak Yuan to support its export-driven expansion, it may now believe a strong Yuan will allow it to bring higher living standards to its population. Notice they just announced that they will allow foreign trade to be conducted in Yuan. That is a big first step to the Yuan taking its place among the hard currencies in the reserve banks around the world.

Eventually inflation will return but with such dramatic asset destruction as we've seen, I'm not sure that it'll be unmanageable. Eventually... you know what they say... in the long run, we're all dead.

Mar 09 04:00 AM

[Sean Maher:]

BrunoT, I suggest you read my posting from 28 August, and those all through September and October...you will find I made clear and urgent warnings of an imminent equity crash in very good time based on severe credit market deterioration evident from late August, but retained a positive dollar view throughout. I'll hold my track record up against anybody's over the last year...including your palm reader.


On Mar 08 03:43 PM BrunoT wrote:

> On Aug 5, 2008 Sean Maher wrote:
>
> "it's now a good bet that on a 12m view, inflation concerns will
> have abated, the dollar will be in a surprisingly strong uptrend,
> and US equities will be materially higher from here."
>
> Beware of those dispensing readings of the future for money. They're
> not much more reliable than palm readers. And like psychics, they
> never seem as proud of crowing about their abject failures as they
> do about the twice a day the stuck clock is correct.
>
> Does about half sound like being "materially higher" to you?

Mar 09 10:33 AM