The Euro Shows Its Real Colors

If you would have told the "economists/analysts" on CNBC or Bloomberg six months ago that the next interest rate move by the Fed would be down, you would have most likely been laughed at. You see, market capitulation in any market is often relative. For many, just when you feel comfortable with a trading range, or trend, it changes. When we slashed rates down to 2%, many individuals (even the doves), said that's more than enough.

A couple bank failures, takeovers, bankruptcies, and bail out later and the markets were screaming for a rate cut. This time it was a cry for a globally coordinated cut, and that's what markets got. It happened to be to the tune of a 50 BP move by the Fed, ECB, BoE, BoC, and the Swedish Riksbank.

Trichet has lied as all central authorities do so seamlessly. He stood tall with his hawkish rhetoric before the urge to inflate took over. Many believed him. I did not. Regardless, I've mentioned on several occasions that the trend for monetary authorities around the world would be to cut rates. The race to inflate was on.

Race to Inflate

For several reasons, the largest being the dire need for credit by the G-7 economies in order to survive, it is impossible for central banks to raise rates. Simply put, the result would be deflation that dwarfs the 1930s.

Up until now, the dollar has taken the brunt of the beating. What we are quickly learning is that Europe and the rest of the world is sitting on more bad paper than they are letting on. Euro LIBOR and other lending rates are through the roof as their credit markets have locked up as well.

How will they respond? They will do exactly what we are doing here in the U.S., but on a smaller scale. The BoE is discussing a bailout to the tune of $88 billion. Germany has recently guaranteed all bank deposits, an action already undertaken by U.K. regulators. Last, but most definitely not least, is the direct AIG (AIG) bailout style intervention that began two weeks ago.

In short, the ECB, BoE, and the rest of the world will attempt to inflate their way out of this mess.

Euro or Gold

This leads us right into an issue that is overdue for discussion. How should we hedge the falling dollar: gold or the Euro? The content of this article leading up to this question provides both my opinion and the obvious answer.

Gold has been, and will always continue to be the best hedge towards any falling currency. It's really a basic notion. As an investment, the rise in value of one currency over another simply equates to the differences in inflation as defined by money supply growth. There are other extraneous factors, but this is theory put to practice (the only acceptable type of theory).

Let's say the U.S. is growing its monetary base (M3) by 15% per annum. This could come via Fed auctions, money used in bail outs, Fed intervention in commercial debt markets, etc. It is all money created by the printing press or growth in credit.

On the other hand, the Euro zone is doing the same thing on a smaller scale. The main difference in the amount of excess that was created is simply the dollar being the reserve currency of the world. This created an insatiable demand for dollars allowing our imbalances to grow enormously.

Understanding that, let's say that Euro zone M3 growth is 10%. Because of the differences in the money supply growth, I would fully expect the Euro to gain 5% in value compared to the dollar. On the other hand gold will gain 15% against the dollar.

You see, gold is the only asset left in the world that isn't somebody else's liability. That was a quality that was overlooked and underappreciated for a long time until recently.

All in all, this doesn't mean that the correlation coefficient between gold and the dollar will be exactly negative one at all times. There are times of panic, hedge fund liquidation, buying/selling by monetary authorities, etc. that affect these values.

In the long run, it's all irrelevant noise. The price of gold WILL show exactly the money supply growth, and right now money supply growth is GROWING EXPONENTIALLY. Got gold?

Disclosre: The author and publisher do not hold positions in the securities mentioned.

Comments

[Smarty_Pants:]

Not surprisingly GLD shot up over $20/oz on increased volume in the last half hour of trading today. Your argument must have been too persuasive to resist.

2008 Oct 09 04:39 PM

[huangjin:]

Remember that all those imbalances came through dollar debt. The dollar decline was itself a bubble, and now only Japan is safe from its popping. Additionally, the Germans may decide they don't want to bailout the PIGS and send the euro the way of the dodo.

2008 Oct 09 05:16 PM

[cjct:]

Euro has the fatal flaw of being governed by a single central bank but multiple national governments. This dichotomy can only be resolved in one of two ways.... 1) the euro disintegrates 2) a Eurozone gov't forms

Which one do you think is more likely...I'll take the former.

2008 Oct 09 05:20 PM

[css1971:]

"Euro has the fatal flaw of being governed by a single central bank but multiple national governments."

You seem to think that national governments matter... Haven't you noticed that when certain banks shout "Jump!", the national governments ask "How high?"

2008 Oct 09 05:40 PM

[dionysos:]

Today's run up in gold reflects currency weakness across the board. Recent rise in US$ is not because of dollar strength, but other currencies relative weakness in perilous times. The market is realizing that gold is the only safe haven in the inflation that must come to stave off deflation. This is Bernanke's main goal: to prevent a repeat of depression by inflating. Gold stocks are currently very undervalued in relation to the price of gold and they will move up at a higher rate than GLD.

2008 Oct 09 07:42 PM

[Talin:]

Monetary authorities in Europe, whatever our ideas, have not done so bad with a single central bank and multiple governements. At least they have not originated this mess created by a Central Bank and a SINGLE government. As for the future who knows, perhaps the world will forget and the dollar can recover a little of the total lost of credibility. Funny that at 1,35 to the Euro people talk of the strenght of the dollar.

2008 Oct 09 08:09 PM

[LCACM:]

There is no choice for US and Europe other than to inflate their currencies. These economies are being devastated by the so called Free Trade ideology. Wall St has coined the word "Proctectionism" so that it can be used to label and ridicule those who propose a saner and Fairer Market. However, the same high priests propounding Free Markets and Cowboy Capitalism have no problem asking the US government to hand them a 700B check. The Free Market can be likened to an Airplane AutoPilot. AutoPilots do a good job of steering the plane when the human Pilot might be asleep at the wheel during long flights, howerver, the Pilot is supposed to take over the controls in treachorous situations such as landing, takeoff, engine fire etc. Deregulation of the last few years is similar to sending a plane full of passengers on a flight without a Pilot, because the Pilot might fall asleep at the controls.

2008 Oct 12 01:08 AM

[Andy Abraham:]

Possibly it is best not to predict..but rather react... ..keep to a plan...with money management and risk management...and hopefully survive this mess..

2008 Oct 15 05:13 PM