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For those who don’t follow at least the big picture of currencies and commodities, here’s something you should read, because you may see that you need to start paying a bit more attention. The US dollars status as reserve currency, though safe in the near term despite the hype otherwise, is ultimately based on confidence, as is the case with any fiat money.

Does gold’s move this past week suggest that the rest of the world has lost faith?

Chronicle of a Mystery: September’s Unexplained Events

Tuesday, September 1st

Markets drop around 2% on high volume, on fears that global stock markets are overpriced and due for pullback during September, historically a losing month for stocks, especially after they’ve risen since March and continue to do so in July and August despite generally declining revenues, earnings, and very mixed news.

Wednesday, September 2nd

A very odd thing happened: potentially very bad news came out. Predictably, stocks dropped again. Shockingly, gold shot up.

The bad news was the ADP non farms payroll indicated worsening unemployment for the US. Because consumer spending is about 70% of US GDP, and the US remains the world’s largest economy, that is very bad news for US and global recovery hopes. Worse still, the ADP report is a leading indicator of the official US government non farms payroll report that would come out 2 days later on Friday. This was a blow to the weakest link of the recovery.

Yet gold rallied hard, up about 5% from September 2nd-3rd. It has since slowed, but neither pulled back nor stopped rising. It didn’t make sense.

Since the crisis began in the summer of 2007, gold has generally gone up with good economic news, and dropped with bad news, since recovery implied inflation, and gold is considered the ultimate inflation hedge. Bad news decreased the chances of inflation, so gold was supposed to drop. Yes, Armageddon-end-of-currency bad news might support gold, but the ADP report was hardly that bad.

Financial writers are paid to explain the markets, so they tried. Common reasons given, however, didn’t make sense. They included:

  • A weakening dollar: Yes, and the sky is blue, too. Gold and other commodities are priced in dollars, so it makes sense that they would rise as the dollar falls and vice versa. However, the USD and gold have been moving in opposite directions for years. The USD didn’t make any huge moves down when gold took off. This is old news that explains neither the timing nor magnitude of the move.
  • Concerns About Recovery and Inflation: Huh? This is a contradiction in terms. Less recovery generally means less inflation, not more, because people don’t spend. It’s usually one or the other, but not both (except for rare cases like the ‘70s stagflation, which was due mostly to a rare quadrupling of the price of an external - oil - that both raised prices and killed the economy). Again, except for end-of-world/currency bad news, gold falls with bad economic news, so recovery worries suggest less inflation or even deflation. In recent years, that has caused the USD and other safe haven currencies to rise, and gold to fall.
  • A “technical” move: A non-explanation. This is what those of us in the analysis business commonly say when we don’t know. Those familiar with technical analysis know that it is a useful tool, but successfully applying it is as much an art as science, and there is wide variation as to how it is applied. Was key resistance broken? Key support held? A series of indicators triggered in the bowels of institutional supercomputers? Who knows? Momentum driven trading explains how the move continues, but it doesn’t explain the timing or extent of the move.

So What’s the Meaning of Gold’s Behavior?

So what does this all mean for the average investor?

Background: Why Money Supplies Ballooned

Those familiar with the story of the USD’s travails can skip this part. Those who aren’t, shouldn’t.

Since the current economic crisis began, the supply of every major currency, including the safe haven USD and JPY, has seen unprecedented increase in supply as governments were forced to pump cash into suddenly depleted banking systems and economies to keep banks alive and economies liquid and functioning, as the subprime lending crisis cast doubt on the value of trillions in financial sector assets.

Governments had little choice. If they didn’t, they faced the immediate certainty of another Great Depression from a domino effect of disappearing banks, credit, business, employment and consumer spending slammed each other down into an accelerating tailspin/death spiral/other dramatic metaphor.

So they bailed out banks, and spent on stimulus programs with new cash, paper or electronic. They bought time to fix things and restore confidence. As long as the world remained in depr-err-recession, money supplies could bloat out while scared businesses and consumers would lock down spending until better times arrived.

The problem was that when they did, there was a strong chance that the unprecedentedly large reservoirs of currency would flood into economies and chase a recession- depleted supply of goods, possibly causing unprecedented inflation, aka hyperinflation.

But that was in the future. Meanwhile, hard times would create enough deflationary pressure to keep the floodgates shut.

The Biggest Too-Big-To-Fail: America and the USD

For the USD, the future problem was compounded because there were already vast oceans of accumulated dollars sitting overseas with Asian, European, and Mideast export economies that had diligently saved their export-earned dollars over the years. They held them because they had confidence in the USD’s value.

Even as they saw the US gutting the dollar, and the value of their currency reserves, the exporters’ options were limited. The US dollar and economy remains, for now, the ultimate too-big-to-fail. Complain too loudly, and they’d drive down the value of their own currency reserves, and possible kill off their biggest customer, for which they had no replacement. So they spent this past year alternately whining about the dollar and supporting it, threatening to replace it, while continuing to buy US bonds and affirming its reserve currency status. As long as worldwide recession restrained spending and even threatened inflation, then the inflation threat was somewhere in the future.Thus the USD is part of a very big confidence game in which many have a huge stake, whether they like it or not. The question is, has this become a different kind of “confidence” game?

However, with some signs of actual bottoming, that future may be getting closer. Now what? Central bankers assure us they have the tools to prevent the threatened severe inflation, especially for the most widely held currency, the USD. International intervention has worked before. Many hope it will work again, but many more, especially those managing the funds of exporters must do more than hope.

A No-Confidence Vote in Currencies?

With most expecting a weak recovery over the coming year, stocks do not appear to be the place to park major piles of wealth, and many of the leading exporters like China and the oil exporters are already diversified into industrial commodities. What choice do they have? Currencies or precious metals.

They appear to be choosing gold, and thus also silver, which tends to tag along with gold, at times even exceed it. They are not choosing the usual safe haven currencies: the JPY, USD, and CHF.

In short, the move in gold is at least a tentative no-confidence vote in currencies as a safe haven store of value. Admittedly, the timing of the current move in gold remains a mystery, but, the bigger picture isn’t.

Who is buying? Not clear at this time. That fact by itself suggests exporter central bank or sovereign wealth funds, which often prefer to act through intermediaries for fear of moving markets against themselves because of their sheer size.

Gold may well pull in over the coming months, especially if stocks make their long anticipated pullback.

In the longer term, gold remains well supported by fundamentals on fears of both inflation (if recovery continues) and deep financial crisis (if they don’t) and emerging market buying.

So, What Do You Do?

Currency traders: Long term bias to commodity currencies: long AUD, NZD, CAD, and EUR as a USD hedge, since the EUR tends to move opposite the USD. Short term, beware likelihood of pullback and use it as a buying opportunity. Those preferring ETFs can consider:

  • RydexShares ETFs: Australian Dollar (FXA), Canadian Dollar (FXC), Euro (FXE), Swedish Krona (FXS)
  • Wisdom Tree ETFs: New Zealand Dollar (BNZ)
  • PowerShares ETFs: Group of 10 Carry Trade (DBV), and U.S. Dollar Bearish (UDN)

Commodity Traders: Long term bias to precious metals.

Stock Traders: Neutral in short term, though we believe there is more to be made playing the downside, from the upper end of multi-month trading ranges.

Income investors: Limit new positions to money not needed in the near term and stick to the commodity or essential service provider stocks we’ve recommended over the past months that pay you in currencies other than USD or at least earn in other currencies. We have yet to find a good precious metals income play. Recent suggestions include:

Communications

Cellcom Israel Ltd. (CEL), France Telecom (FTE) Telefonica (TEF)

Canadian Oil/Gas Energy Income Trusts

ARC Energy Trust (OTCPK:AETUF), Claymore/SWM Canadian Energy Income Fund (ENY), Enerplus Resources Fund (ERF), Peyto Energy Trust (OTCPK:PEYUF), Provident Energy Trust (PVX), Vermillion Energy Trust (VETMF.PK)

Canadian Energy Infrastructure Income Funds

Altagas Income Trust (OTCPK:ATGFF), Pembina Pipeline Fund (OTC:PMBIF)

Canadian Utility Income Trusts

Atlantic Power Corporation (OTC:ATPWF) and some very positive clarification from their CFO Mr. Patrick Welch, Bell Aliant (OTC:BLIAF)

Canadian Health Care Income Trust

CML Healthcare Inc. Fund (OTC:CMHIF)

Canadian Real Estate Income Trusts

Canadian Apartment Properties REIT (OTC:CDPYF), Northern Property REIT (OTC:NPRUF), RIOCAN REIT: (OTCPK:RIOCF)

Energy Infrastructure Master Limited Partnerships (MLPs)

Buckeye Partners (BPL), El Paso Pipeline Partners (EPB), Enterprise Products Partners (EPD), Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP), Magellan Midstream Partners (MMP), Nustar Energy (NS), ONEOK Partners (OKS), Sunoco Logistics Partners (SXL), TEPPCO Partners (TPP), Tortoise Energy Infrastructure Partners (TYG)

Coal MLPs

Alliance Resource Partners (ARLP), Northern Resource Partners (NRP), Penn Virginia Resources Partners (PVR)

Other MLPs

Terra Nitrogen Company, L.P. (TNH), StoneMor Partners (STON)

Disclosure: The author hold positions in the above instruments.

Source: Do Gold's Recent Moves Indicate Global Confidence in Currencies Is Unraveling?