US Dollar Not Indicative of Gold

Performance of gold is often associated with that of the US dollar. Yes, gold is denominated in the dollar and mostly moves in the opposite direction of the dollar index. But this is only a partial truth and not the essence of the subject matter.

It is important to remember that the US dollar is not a predictor of gold. The opposite is true: gold typically leads the dollar. The key factor that in turn moves gold is confidence and trust in the world financial system.

Every currency in the Dollar Index and in the world is just as fiat as any other. In other words, the only backing for modern currencies is the trust in the government that prints it. In fact, the US dollar has one advantage over other paper money. It is the world’s reserve currency, which increases its demand, at least for the time being. Today about 65% of all countries’ foreign exchange reserves are held in the dollar; the euro is a distant second at 25%.

Today’s financial system is global and interconnected. Currency exchange rate fluctuations indicate money flows from one country into another. While there are many reasons for these fluctuations, they are not necessarily related to the confidence in the financial system.

A fall in the dollar by itself does not signal a bull market in gold. A real gold bull market is when the yellow metal value grows in all currencies, not just the dollar.

Rather, what is more important for gold is the behavior of debt markets – the best proxy for financial markets risk.

It is a widely known fact that the US Treasury bonds are being supported by foreigners who continue to use their trade surpluses to purchase US debt.

China and Japan now hold over $1 trillion in US treasuries. The increase in debt holdings cannot continue into perpetuity and at some point, if not already, the two countries will have too much exposure. It is absurd to suggest (as in the recent UK Telegraph article) that China will threaten to start selling treasuries. For a dangerous situation on the bonds and the dollar to unfold, they do not even need to sell: just stop or reduce new buying, especially since purchases are now at an all time high. Direct selling will cause huge losses for China and the Chinese know this. They see an easier and smarter way to resolve this situation.

The center of economic power is shifting to the emerging economies in Asia. Asia’s trade volume with South America, Africa, as well as other commodity producers such as Australia, Canada, and others is increasing. At some point in the future, Asia will be able to turn its back on the US and risk only a diminishing portion of its trade. They will have no need to reinvest funds into the bonds and the dollar to prop up the US economy.

Chinese and Japanese foreign exchange reserves will instead be redirected to the third world markets, where the US is already losing its influence. The US will have to respond by loosening foreign investment restrictions to keep the funds flowing back into the country. And the valuable assets that the Chinese are after are not bonds, but real assets such as land, real estate and key US corporations, the same corporations that have made much of their money thanks to outsourcing into China.

Central Banks Starting to Catch Up

As we wrote in our August 2 article, the ongoing correction in the stock markets is not isolated to the US. The latest wave of panic selling came from Europe. A record amount of new funds since September 2001 was injected around the world by the Fed, ECB and BOJ. By the use of short term funds, the central bankers hope to restore a market for mortgage backed securities so that the financial institutions can at least determine the extent of their losses.

While the central bankers may accomplish this goal for the short term, the real problems will emerge this fall when a massive number of floating rate mortgages will experience their first interest rate adjustment. Faced with a possibility of deflationary style recession and a housing bust (as experienced by Japan) the Fed will be forced to continue massive monetary inflation. To prevent a ripple effect through the economy, the Fed will have no choice but to start cutting rates.

We are only seeing the beginning of a new money creation wave by central banks and this is a very bullish situation for gold. But don’t wait for gold to explode overnight; sometimes it can take a few months for the fundamental events to filter through the markets. We are not selling, but buying selectively, as this is just another difficult summer season.