The Always Precarious Dollar (and Its Impact on Gold)

click to enlarge image

The dollar is currently precariously perched right above 70 on the USD Index chart. Right around the beginning of 2005, the dollar was in a similar situation when it consolidated around the 80 mark and retraced back above 90 for an entire year and then slowly grinded down for the next 2 years.

Everyone knows the dollar is being sacrificed by the Fed in order to fund the massive American liabilities. The chart above clearly demonstrates a flight from the dollar. It’s been in a bear market since '02.

Currently there seems to be a concerted effort to forestall any further short-term declines in the dollar and the Fed is making noise about fighting inflation. I believe they are serious at least for the short-term. Unfortunately, there is not much the Fed can do at this point and this is clearly evident when the best the Fed can do to ‘fight’ inflation is to ‘not’ raise interest rates. If they continue to keep interest rates low, inflation will continue to spiral out of control. If they begin raising rates, then they will force the housing market and credit/banking market into a tailspin. Not a pretty picture.

If the central banks are successful in sustaining a minor rally from this point, then use this ‘bought’ time to further diversify any dollar holdings into something more stable. The most important of these items would be gold and silver, as these will regain their monetary status as the financial world implodes around us. Large integrated producers of commodities should also be part of your core holdings. Top these off with a smaller percentage of the mid-tier producers and if you are adventurous enough then speculate in a diversified basket of junior explorers. Oil is a bit frothy right now so I would avoid adding large energy positions, unless they are uranium issues. Once oil comes back down to earth begin looking for good companies to accumulate.

Once the dollar index breaks below 70, who knows how much further it has to fall. Jim Sinclair has a price target of 50. Doug Casey says 0, since that’s its intrinsic value. I’d say that both will be hit at some point. The important thing to keep in mind is that the dollar has much further to fall. It’s just a matter of time.

When you consider the amount of dollars held as currency reserves around the world, it is in the best interest of everyone involved for a steady and orderly decline. Such a massive liquidation and reallocation will take several more years to play out. Currency movements tend to be excruciatingly slow. However, since it’s such a massive market, small movements tend to reflect massive transfers in wealth.

Currently, the massive transfer is occurring at the expense of those holding the most US dollars as foreign reserves, namely, Japan, China, and the major middle-eastern oil exporters.

It’s an enormous game of hot-potatoes and no one wants to be holding the biggest bag in the end.

What does this mean for gold and gold-shares? Since there is such a highly-inverse correlation between the dollar and gold, any amount of consolidation in the dollar will most likely cause a consolidation in gold. And that’s exactly what we’ve seen these past few weeks in gold. The gold shares, on the other hand, have been obliterated and largely forgotten. I believe this is a symptom of the credit crisis where anything and everything that can provide liquidity has been sold to meet margin calls and to lower risk exposure.

This situation will not last very long. By nature I am a contrarian, so the present environment of extremely oversold mining stocks has me giddy with excitement. Remember the famous saying, “Buy when there is blood in the streets.”

Once the dollar breaks through 70, I can easily imagine gold running to $1500, $1650, then $2000. These are the round numbers and "Angels" that Jim Sinclair so often refers to in his musings.

Comments

[bbzz24:]

Many people seem to forget the real reason behind the dollar rally from 1.36 to 1.14 and back to 1.25 just in the calendar year 2005. That reason was the congress allowed U.S. corporations to repatriate foreign profits and pay only 15% corporate gains tax instead of 35%. If you look at those sharp 5% reversals the 1st weeks of 2005 & 2006 it seems that those movements had to do much more with the 'calendar' than any shift in fundamentals. And Warren Buffett misjudged this important factor and lost some 2bn on his euro long bet in 2005, so don't feel deflated if you seem to be sinking short term.

2008 Jul 09 06:44 AM

[CaptBob:]

The only thing holding up the dollar is other country's pursuing the same "strategy" with their own fiat currency's. It looks like a race to the bottom!!.
Our gain in trade balance will only result in the dollar holders around the world exchanging them for other currencies as fast as we can accumulate them. At least we can use them to rescue Banks and Housing-(simultaneousl... since they're joined at the "Mortgage"), and won't have to print more, but we will anyway I'm sure, there's always an excuse once "you're addicted" it's just sooo easy.
Pity Asia and the Mid-East still won't buy from us--well maybe food--, can't let the price of that slip.

2008 Jul 09 12:05 PM

[secmaven:]

Giddy with excitement about the prospects for mining stocks? When a speculator can get 2:1 leverage on gold itself in an ETN, ie. DGP, why the Hell risk the politics, labor troubles, power shortages, cost of production overruns, etc. etc. in a mining stock?

2008 Jul 09 01:31 PM

[GMiki1:]

Why risk your money in mining stocks? Because when the mania hits--eventually--you have the chance to make 10 times, 20 times, even 500 times (or more) your investment.

2008 Jul 09 05:23 PM

[User 30121:]

BUY Gold and Silver, take PHYSICAL CUSTODY of every bit of it, and sit back and wait..(smiling as you go)!

2008 Jul 09 05:58 PM

[sorgmot:]

The index discussed above falls for 40 years and ends at 30 in 2048.

Commodities triple in US $ terms by then. The bear takes over the US stock and bond markets.


Study England history fo the 1930 to 1980 period for the model.

2008 Jul 09 07:31 PM