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There are interesting developments regarding the future of the Euro. Will it become a real alternative to the USD? Can the Euro have such standing as to be a real alternative to the USD 'system'? The USD is the world reserve currency, and I call the ‘USD system’ the entire interlinked economic trade web.
If the Euro can indeed become a real alternative to the USD, it will have to be able to run consistent monetary policy separate from the USD, and a better policy at that. However, even though the ECB has resisted temptations to cut interest rates along with the US, the value of the Euro has risen to pain thresholds for EU trade because of the higher Euro interest rates.
If the Euro is too high, EU exports are more costly, and EU manufacturers have costly foreign exchange losses, as they get paid in USD but have to pay wages and costs in Euros. Many EU businesses have contracts in USD, but still have to pay costs in Euros, and it hammers their profits if the Euro remains so strong.
USD zones
This foreign exchange dilemma is a good example of the challenges of trying to break away from a falling USD in the USD economic system. EADS-Airbus, for example, states that the cheap USD is putting excruciating pressure on their cost structures as an example. They say every point fall in the USD costs them a $billion a year in FX losses. France is screaming. This kind of pressure in the EU has manufacturers looking to move production facilities into ‘USD zones’ and out of EU zones, thus a big strengthening force potentially for the USD.
These EU manufacturer trade FX losses are a really big issue, and a perfect example of the difficulty any US trade partner faces in trying to run independent monetary policy from the USD, such as having interest rates stay firm – EU – while the US cuts.
Euro to become a USD proxy?
The question arises then, since the EU is finding that independent interest rate policies cause excruciating pain, can the ECB maintain monetary policy independently from US monetary policy?
Will the Euro become a proxy for the USD? I.e. have to follow along when the US eases? Of course, nations that cut interest rates along with the USD devalue their currency along with the USD, and end up importing inflationary pressures. So far, the ECB has resisted this temptation.
Nevertheless, in spite of Germany’s firm view on restraining inflation, there is immense pressure on the ECB to cut interest rates along with the US, as the weaker EU economies such as France and southern Europe are screaming bloody murder and threatening to bolt the Euro. Since the EU economy is very disparate in terms of strength, can one Euro fit all?
I’m thinking the answer is no. Something has to give. Either the ECB will have to relent and cut interest rates along with the US, and effectively devalue with the USD, or frictions over tight money policy of the ECB may split the EU monetary union. Such a case, as say France bolting, or Italy or Greece, would seriously damage the credibility of the Euro as a USD alternative.
The price for not being a USD proxy (following along with US monetary policy on interest rates for example) is possibly too high for the ECB and the EU economies to tolerate.
Our other big trade partners have similar dilemmas. China imports inflation from the US as they keep their currency cheap relative to the USD. The rapidly growing USD reserves have to be washed into the Chinese economy. China also has an inflation dilemma, as they are running around 7% inflation, while the EU is running around 3 to 4%.
Japan has similar issues with the Yen vs the USD. If the USD falls in value to the Yen the Japanese manufacturers start getting the heat too, and prices for their exports rise.
Can anyone run monetary policy independent from the US?
Can they stand the heat if they try to run independent monetary policy?
It seems that everyone is having the same dilemma. How to run a monetary policy independent from the USD system? A falling USD puts immense pressure on our trade partners to follow suit. If they follow suit, inflation builds. It’s a dilemma.
Our Oil trade partners in Opec have similar problems. They have pegs to the USD but, because of that, are importing inflation, and it’s getting to a critical point. They have talked about a common currency there. The trouble is, they will end up in the exact same position as the EU is with the Euro, and then having pressure to become de facto proxies for the USD anyway, like the EU is having with the Euro. It would seem that exiting a pegged exchange rate to the USD is a more or less insoluble problem.
What all this means is that the world is having a really hard time running monetary policy independent of the USD. They have huge pressures to follow suit with US interest rates for example. If they cut USD pegs, intolerable strengthening occurs in their currency vs the USD because the US fiscal and trade situation is such a mess.
Gold in USD proxy situations
Moving to gold, the difficulty of breaking with the USD system means that our trade partners have immense pressure to devalue along with the USD, and also to follow suit with US interest rate policy. This in effect gives the USD significant support, and prospects for a USD collapse are delayed as the other currencies in effect support the USD if they devalue along with it. This is why gold has not reached its inflation adjusted price to back in 1980.
Let’s pick a figure of $500 gold in 1980 just for an exercise. Since 1980, prices in the US have roughly tripled. That would mean that gold should be $1500 now (I’m not using the peak gold prices back then in this example). But gold is $800 to $900 now. Why is that?
Proxy currencies hold up USD
That is because our trade partners, particularly Japan, have effectively debased their own currencies to maintain nice trade surpluses with the US. If they had not done that, the USD price of gold would already be over $1500, and would likely be looking to get over $2000 and $3000 with the horrid US fiscal situation.
In the case of the Euro, we are reaching a moment of truth, as to whether the EU can stand the internal bickering over a steady EU interest rate, in the face of US cuts. If they break and cut interest rates along with the US, they effectively become USD proxies. They end up supporting the USD in effect, and gold stays lower than it would otherwise be.
This exact situation is one reason the Euro has weakened since it hit 1.60 USD. Gold broke along with the Euro fall from 1.60, as there are expectations in the gold market that the ECB cannot hold a steady independent policy from the USD, and will have to cut interest rates as the US does. The internal EU pressure is so intense that if they don’t start weakening the Euro, there is a real possibility that some of the weaker southern European economies will bolt the EU monetary union. That would be a disaster for the Euro.
USD proxies cause gold to rise in all currencies
Of course, all this logic would state that, if our trade partners co devalue with the USD, then gold would rise in all currencies. That is exactly what is happening in recent years. But that also means that our trade partners are de facto proxies for the USD. That means they import inflation.
This is the reason the USD is called the de facto world reserve currency. US interest rate policy and monetary policy ends up being world monetary policy. I also view Japan as a total USD de facto currency, as they may have really cheap interest rates, but are so sensitive to USD monetary policies and have been willing to unilaterally support the USD in huge measures.
Overall, gold should remain in its long term uptrend. The volatility of gold prices is largely due to lots of speculation in it, and as the Euro falls for example, the USD shoots up and traders exacerbate gold price swings on any news of the Euro exchange rates. This is particularly true with respect to gold ETFs which make it so easy for speculators with short term gold positions to be bought and sold at a whim. Again, a big volatility lever on gold.
April 20th, we alerted subscribers that we suspected the USD to be bottoming, and gold to correct. That happened, and the Euro is also breaking down a bit as doubts appear they will hold interest rates steady amid weakening economic statistics. The USD is rallying, and the big question right now is what is next for the Euro, will the ECB blink in the pressure to cut interest rates? Will they relent, and follow US interest rate and monetary policy?
Paradoxically, as our trade partners become de facto USD proxies, the value of gold rises in all currencies, but does not rise as fast as the USD fall is tempered.
Credit crisis still a big factor
We hear news that the credit crisis is abating. Our last public article discussed how gold shot up way over its long term uptrend to over $1000 due to the credit crisis. Some improvement in that situation allowed gold to retrace some of that overshoot. Going forward, gold will be playing with this credit crisis premium as new developments, good and bad, appear in the world financial/banking/credit markets.
While we can consider that gold likely will continue rising in all currencies, as they follow suit with inflationary USD policy, the credit crisis is a big wild card on shorter term gold prices.
The Prudent Squirrel newsletter is our financial and gold commentary. Subscribers get 44 newsletters a year on Sundays, and also mid week email alerts as needed. We alerted our subscribers April 20 that the USD was bottoming. The USD has strengthened significantly since. The alerts include quick notification of important financial news developments by email. Subscribers tell us that the alerts alone are worth subscribing for.
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Christopher Laird
Editor-in-Chief
www.PrudentSquirrel.com
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Chris Laird is not an investment advisor/professional. This article, and the PrudentSquirrel newsletter and alerts, are general market commentary only. They are not intended as specific advice. You should talk to your own investment professionals for specific advice.
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