The currency markets have a huge weight hanging over them these days. It has been eight long years since the global economic crisis threatened to decimate markets. Central bankers, as financial firefighters, arrived on the scene with tool boxes filled with accommodative fixes and in Europe, Asia, and the U.S., they remain on a dovish monetary path.
European and Japanese interest rates are in negative territory. U.S. rates are currently at 25-50 basis points on the short-term Fed Funds rate, and the Fed is threatening to hike the rate by 25 basis points by the end of 2016. The market consensus now shows an 80% likelihood of a hike. At less than 1%, the yield on the dollar remains close to a historic low.
The U.S. economy is growing at a moderate pace, and the central bank has officially moved from accommodation to tightening. However, the short-term rate is lower than it should be at this time given economic conditions. The Fed continues to look over its shoulder at the rest of the world and fear of the next economic shoe to drop has prevented the central bank from acting to fulfill its promise to increase short-term rates this year.
Meanwhile, the only thing holding the U.S. currency down these days could be uncertainty surrounding the Presidential election on November 8. However, on Tuesday, the dollar index broke above technical resistance at 97.61 on the December futures contract for the first time since March 10, 2016.
One sign that the dollar and all other currencies have a real problem today is the price action in gold and bitcoin in 2016. These two assets have outperformed all forms of paper money, and if central banks remain on the same course, they are likely to continue higher in the months ahead. Gold and Bitcoin have signaled that faith in government issued paper money has declined this year.
Highs in June and July
Gold and Bitcoin both made highs in July following the surprise Brexit referendum.
Gold rallied from the $1,046 level in December 2015 to highs of $1,384.40 on July 6. The increase of 32.4% was followed by a correction that took the yellow metal to lows of $1,243.20 on October 7, but even at those lows, gold was still up 18.9% from the December price. Gold was trading around the $1,255 level on Tuesday, October 11.
As the daily chart of Bitcoin highlights, the price of the cryptocurrency climbed from $245.59 on October 12 to highs of $768.24 on June 16, an increase of almost 213% over the past year. Bitcoin dropped to lows of $552.82 on August 2; it was still more than double the price in October 2015.
Bitcoin has outperformed gold on a percentage basis over the past year and was trading at the $638.70 level on Tuesday.
Gold and Bitcoin are alternative currencies, and both are global means of exchange. Gold is the oldest currency in the world. The yellow metal has been around much longer than any paper currencies now in circulation around the globe. Bitcoin is still a newcomer on the scene, but it has gained popularity and acceptance despite some speed bumps like the Mt Gox issues that caused the value to fall and questions about the future of the cryptocurrency. Mt Gox was handling 70% of all Bitcoin trades in 2013 before its insolvency in 2014. However, the price action in Bitcoin since the Mt Gox problem is proof that it has survived and thrived as an alternative currency.
The one thing that gold and Bitcoin have in common is that they cannot be manipulated by any central bank or monetary authority in the world while other paper currencies can.
Central banks and debasing paper money
In the aftermath of the 2008 financial crisis, central bank policies of quantitative easing and low interest rates effectively increased the availability of traditional paper foreign exchange instruments. In an attempt to stimulate economies by increasing borrowing and spending and inhibiting saving, governments created an avalanche of liquidity in foreign exchange markets.
One of the reasons that gold and Bitcoin have done so well over the past year is that both of these means of exchange operate independently of central bank policy. Monetary authorities can print paper currency to their heart's content, but they cannot create more gold or Bitcoin. The governments of the world hold over 30% of all of the gold ever mined in the history of the world. They hold the yellow metal as foreign exchange assets and can sell and buy the metal at the current market price. However, they cannot create more gold out of thin air. When it comes to Bitcoin, the cryptocurrency operates outside of the purview of the world's central banks.
Quantitative easing has swelled the balance sheets of central banks around the world. The European Central Bank recently included some corporate debt issues into their QE program. In Europe and Japan, short-term rates remain in negative territory; it costs money to store paper cash. In the U.S., the Fed hiked rates for the first time in nine years in December 2015 and promised 3-4 more increases in 2016, but so far, rates have not increased by one basis point.
Even if the Fed increases the Fed Funds rate by 24 basis points at their December meeting, which they are likely to do, it will only result in a rate of 50-75 basis points. The bottom line is that central bank policy has resulted in lower currency values across the board and we can see that clearly by the price appreciation of alternative currencies like gold and Bitcoin.
Do rates matter?
Interest rates matter when it comes to other investment vehicles such as stocks, bonds, and currencies. We are trained to gauge the value of currencies by measuring one against the other; for example, the dollar versus the yen or the pound versus the euro. However, when measured against gold or Bitcoin, the value of all currency instruments have declined in 2016 against the two alternative means of exchange.
The Fed has not increased interest rates in 2016 because of fears surrounding Asian contagion from China early in the year, uncertainty about the Brexit vote and ramifications about the U.K. departure from the E.U., and other reasons that have caused the central bank to exercise extreme caution. While the U.S. economy is growing at a moderate pace, inflation has moved toward target levels, and jobs data has improved, the Fed has not acted yet but has signaled that a move is "imminent" at the December meeting.
The Fed knows that the stock market is watching carefully and could decline if they hike rates. After all, low rates have driven capital into equities. It is possible that the U.S. Presidential election on November 8 has been a reason for the latest delay in hiking rates. However, a December hike seems likely at this point, and it will be fascinating to see how gold and Bitcoin react.
The oldest and newest alternatives tell a story
Market expectations are that the Fed will move in December. Higher interest rates in the U.S. will support further gains in the dollar and given the inverse relationship between gold and the dollar, the price of gold has declined as the dollar appreciated over recent sessions. We must remember that even if the Fed acts, rates in the U.S. will remain very close to historic lows, and there are no signs that the central bank will pursue an aggressive tightening stance in 2017. If anything, a rate hike in December could be a one and done situation.
Meanwhile, gold and Bitcoin have both performed well over the past year, and that is a statement about the value of the dollar, euro, pound, yen, and most other paper currencies. The government issued paper money relies on the full faith and credit of the nations that print the notes and mint the coins. Unless those notes have gold or Bitcoin behind them or the coins are made of the alternative currencies, the past eight years of accommodative monetary policy has left a lasting and perhaps devastating effect on paper monies.
The oldest and newest means of exchange in the world have told us a story over this past year. That story is that the value proposition for paper money is on the decline and gold and Bitcoin will continue to make higher lows and higher highs. It will be virtually impossible for monetary authorities around the world to reverse the damage done to their foreign exchange instruments over recent years in a free market.
Gold and Bitcoin are the ultimate beneficiaries of central bank policy, and that is not going to change anytime soon. I am a scale down buyer of both alternative currencies in the weeks ahead as we have yet to feel the full effects of accommodation. Hold onto your hats, when the dam breaks things could get hideous for paper money and assets.
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