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Big Changes Afoot on USD Pegs - Inflationary Pressures
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The August - September credit crisis has had many ramifications. One of the largest is that it reveals pending changes in USD currency pegs with our trading partners.
Hedge funds are about to take advantage of inflationary pressures as the US cut interest rates during the credit crisis, and our trade partner nations move away from pegging their currencies to a falling USD. As the USD devalues, that causes inflationary pressures in nations with big USD inflows. In many of these nations, inflation is now on the order of 10% and more. If they try to keep a USD peg and cut rates with the US, a falling USD puts more inflation pressure on them. As a result, these nations are taking various steps to combat importing inflation pressures from a falling USD. They have stated they will not cut interest rates along with the US (China and Kuwait), and or are outright abandoning their long standing USD pegs. Much of this is driving gold price rises now.
Our trade partners such as China, emerging markets, and the Middle East oil nations have pegged their currencies to the USD to maintain trade advantages, and or keep their currencies cheap to the USD. This enables them to foster exports to the US.
Even the Oil nations have benefited from supporting the USD in the past, as oil is cheaper than it might be in the US and they can both support the USD by pegging to it, as well as support the US economy - in effect subsidizing US oil imports. It is not in their interest for a falling USD to rocket energy prices in the US.
However, many of these longstanding USD supportive policies are changing. China, for instance, pegs their currency to the USD to keep exports flowing. The trouble is, that is causing inflationary pressures there, as they accumulate hundreds of billions of USD trade surplus each year that has to be washed into local currency, and this finds its way into their various bubbles.
Credit crisis was a catalyst to cut USD pegs
When the credit crisis emerged, and central banks flooded money into the financial system, the US ended up cutting its interest rates .5%, which undercut its premium over other currencies. This reduced the incentive to hold USD investments such as Treasury bonds. It further causes inflationary pressures on everyone attached to this USD peg (Pegging their currencies to the USD for trade advantages) as the USD falls in value.
When news came out this week about $163 billion of ‘withdrawals’ from USD investments in August, with large Asian central bank selling of USD bonds, the USD again fell below 78 on the US Dollar index basket of currencies. It is not altogether clear that this is a new pattern however, as much of that selling was tied directly to the credit crisis in one way or another.
The USD might have fallen far more in that period had there not been flight into the USD then, as institutions and companies had to hoard USD to cover operations as short term commercial credit dried up.
Nevertheless, when the US cut its interest rates to calm markets during that crisis, it highlighted the inflationary pressures on our trade partners who had been pegging their currencies to the USD.
Kuwait, China, and other nations stated they do not intend to be handcuffed with US interest rate cuts, and cut along with the US, because that will cause already further excessive inflation in their own countries.
The USD is finding significant downward pressure as a result. It does not help that the US does not mind a falling USD (rhetoric aside that the US wants a strong dollar) because that helps address the US trade deficits.
Gold has been very strong of late, rising over $100 since its lows which appeared in August- Sept during the credit crisis driven market sell offs. Gold was sold along with stocks and such as cash was in such demand, and funds, institutions, and businesses needed liquidity and cash when commercial paper froze up.
Gold is rising recently due to changing currency regimes world wide, where they are deemphasizing pegging their currencies to a falling USD. Previously, before this USD de-emphasis emerged recently, the USD was held up by our trade partners to foster exports to the US. Now, that policy is causing unacceptable inflation in their own countries, so they are deemphasizing pegs to the USD. That hurts the USD, and rallies gold.
Not only that, but as central banks import inflation from Japan and the US, gold rises in all currencies. Gold is acting now as a central bank reserve asset currency, and is rising from inflationary pressures in all currencies. It is estimated that world money growth is over 10%. Gold is not only rising now due to speculative activity, or commodity strength in oil for example.
Central banks are caught in a dilemma. If they stay pegged to the USD and debase along with it, inflation runs rampant. If they cut the pegs, their exports will suffer. Right now, inflation is winning the day, and gold reflects this.
The Prudent Squirrel newsletter and alerts are Chris Laird’s financial and gold commentary. Subscribers get 44 issues a year and mid week email alerts as needed.
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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, is general market commentary only. It is not intended as specific advice. You should talk to your own investment professionals for specific advice.
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