|
Longtime readers of my commentaries may recall
that I have been waiting for the dollar to fall while US interest
rates rise at the same time. Even though it may not be intuitive
that the dollar could fall while interest rates rise, I think
current events in both China and Japan are setting the stage
for it to happen.
To show how significant recent announcements
from both China and Japan are I am going to recap the events
leading up to them. If the following is too brief, I suggest
you read past commentaries on my website (www.paulvaneeden.com)
for more background.
Since 1992 more than four trillion dollars of
foreign capital have been invested in the US. This capital
influx was due to a series of currency crises, beginning with
the Brazilian Real in 1992. Capital, seeking a safe haven,
poured into the United States. Initially, this influx of capital
caused US interest rates to fall, US corporate profits to
rise and consumer spending to increase. The resultant bull
market in stocks and bonds was fertile ground for investor
speculation and gave rise to the high-tech, or Internet bubble.
When the high-tech bubble burst, the Federal Reserve reacted
by artificially driving interest rates even lower, causing
a real estate bubble in the US and averting the collapse of
the broader US stock market.
When the Southeast Asian currency crisis began
in 1996 with the fall of the yen, the extraordinary amount
of capital that flowed into the US caused an unprecedented
rise in the US dollar exchange rate. This increase in the
US dollar exchange rate in turn caused a decrease in the price
of all things priced in dollars: oil, commodities, metals,
gold and, of course, all US imports. Lower import prices in
the US in turn lead to an expansion of the US trade deficit.
At the same time we also saw the emergence of
China as an economic powerhouse, with a massive shift of manufacturing
capacity away from North America and Europe to China. In order
to maximize the benefit of the strong US dollar, both China
and Japan elected not to sell the trade dollars they were
receiving back into foreign exchange markets. Instead, they
bought US Treasuries with those dollars.
Under normal circumstances, when a country such
as Japan receives trade dollars due to its trade surplus with
the United States, it sells those dollars in the foreign exchange
markets. By selling dollars and buying yen, the trade imbalance
would lower the exchange rate of the dollar and increase the
exchange rate of the yen, thus increasing the cost of exports
from Japan and increasing the cost of imports in the US, which
would eventually neutralize the trade imbalance. But because
both China and Japan (and several other Southeast Asian countries)
withheld their trade dollars from foreign exchange markets,
their export prices and US import prices were kept low. This
caused an exacerbation of the US trade deficit, and it also
kept US interest rates low since the bulk of those dollars
were invested in US bonds.
Oil and metal prices declined precipitously
during the late 1990s because of the rise in the US dollar
exchange rate. Declines in metal and oil prices were far less
pronounced in many other currencies and, in fact, the gold
price increased in some currencies even while it was falling
in US dollars. I realized during the late 1990s that the gold
price (in US dollars) would not sustain a rally until we saw
the end of the rise in the dollar itself. Between 1999 and
2001 the dollar rally petered out and by 2002 the dollar was
entrenched in a bear market as the combination of falling
interest rates in the US and the trade deficit took their
toll. Oil, commodities, metals and gold prices started rising.
The increase in most metals and commodity prices
were initially just a reflection of the falling US dollar
exchange rate; however, because of the expansion occurring
in China, among other things, some commodities and metals
prices rose more than what could be accounted for by the dollar
alone.
The gold price, on the other hand, was almost
exactly paired to the US dollar exchange rate up to the middle
of 2005.
Now we can evaluate the current situation with
the twin deficits of the United States.
The US trade deficit simply means that US residents
buy more imports than what they export. The net result of
the trade deficit is that US dollars are being sent to other
countries, and, as mentioned earlier, under normal circumstances
those dollars would have been sold in foreign exchange markets,
putting downward pressure on the dollar. A weaker dollar would
translate into higher prices for US imports and lower prices
for US exports and that would in turn cause a reduction, or
elimination, of the trade imbalance. Therefore, the US trade
deficit will eventually cause the US dollar to decline. The
only reason it has not yet done so is because China, Japan,
and several other countries are not selling their US dollars,
but investing them in US Treasuries instead.
That brings us to the US fiscal deficit. A fiscal
deficit arises when the government spends more than it receives
from taxes. The US fiscal deficit is much larger than the
budget deficit and contrary to what the media and politicians
would like you to believe, the US fiscal condition is worsening,
not getting better.
The current debt limit for the US government
is $8.184 trillion and if that limit is not raised by the
middle of the month the government will likely go into default.
All it means is that lawmakers will vote to increase the debt
limit. But the amount by which they will increase the debt
limit is what is interesting. The current proposal is for
an increase of $781 billion. Why $781 billion? Probably because
that is more or less what they expect the fiscal deficit will
be for the next twelve months, or so.
During fiscal 2005 (that ended on September
30, 2005) the government’s debt increased by $554 billion.
Since then the debt has increased by $337 billion, which,
when annualized, comes to $814 billion. Don’t be misled
by budget deficits: politicians can budget all they like but
their spendthrift ways become evident in the increase in debt.
As an aside, the current debt of $8.27 trillion
does not include unfunded liabilities of the US government,
such as Social Security, Medicaid and Medicare. Including
unfunded liabilities the US government is approximately $46
trillion in the hole.
The fiscal deficit means the US government continually
has to issue more and more debt to finance its spending and
the issuance of debt means an increase in the supply of US
bonds that will ultimately lead to lower bond prices and higher
interest rates. This is where the trade deficit and the fiscal
deficit meet. Just like the trade deficit implies the dollar
will fall, the fiscal deficit will ultimately cause US interest
rates to rise.
Recall that China, Japan, and others were buying
US Treasury debt (bonds) with their trade dollars instead
of selling those dollars into foreign exchange markets. That
is what kept the dollar afloat, but it is also what kept US
medium to long term interest rates so low since no matter
how much more debt the government issued, these nations stood
ready to buy it.
Looking at this I realized that we are going
to witness an unexpected turn of events. When China and Japan
decide to stop buying US Treasuries with their trade surplus
dollars, the US dollar exchange rate will fall simultaneous
with rising US interest rates. This is not intuitive since
common dogma suggests currencies rise when interest rates
rise and fall when interest rates fall. Yet I believe that
the US dollar is going to fall while US interest rates rise.
You probably already figured out how this works:
When China and Japan stop buying US treasuries with their
trade dollars they will no longer be supporting the US government’s
debt issues, which means the US fiscal deficit and the resultant
necessity to issue bonds will cause bond prices to fall and
interest rates to rise. At the same time, China and Japan
will have to do something with those dollars. My suspicion
is that they will gradually start selling more and more trade
dollars for their own currencies so that they can invest in
their own economies.
I am not suggesting that China or Japan will
start selling massive amounts of dollars that are currently
held in their foreign reserve accounts, merely that they will
reduce the rate at which they are accumulating US dollars
in their foreign reserve accounts.
It has always been clear that China and Japan
will support the US dollar only as long as it is in their
interest and I have made the point that it is in their interest
only while US consumption of their goods continues to grow.
We have seen that US economic growth is faltering and therefore
I believe we are at the end of their support of the dollar.
In December a Chinese newspaper, called The
Standard, printed an article that quoted Mr. Yu Yongding,
a member of the monetary policy advisory committee to the
People's Bank of China, as saying that China should weaken
the link between the yuan (renminbi) and the US dollar to
make the exchange rate more flexible and improve the Chinese
government's ability to manage their economy. Yu suggested
that the weighting of the US dollar in the basket of currencies
against which the renminbi is set should be reduced, thereby
reducing the impact that changes in the US dollar would have
on the value of the renminbi.
The next day Mr. Yu Yongding was quoted by the
same newspaper as saying that Chinese firms should get ready
for a strengthening of the yuan (renminbi) during the next
one to two years. The "fuller the preparations, the better,"
he said. The same article mentions a research paper obtained
by Reuters, wherein Mr. Yu Yongding suggested China could
reduce the growth in its foreign reserves by running expansionary
fiscal policies and investing in infrastructure and research
and development.
It seems to me that China is getting ready to
do exactly what I expected they would do: start selling trade
dollars and investing the proceeds into the Chinese economy.
But if China abandons the dollar, Japan will follow, because
supporting the dollar is not possible for either China or
Japan alone: it requires both of them to act in concert.
And indeed, last week we learned that Japan
is considering raising interest rates. For almost ten years
now Japanese interest rates have been near zero in an attempt
to avoid a deflationary collapse. Such low interest rates
meant little demand for Japanese bonds and hence virtually
no investment demand for Japanese yen. Instead it created
what is called the yen carry trade. Large investors could
borrow yen at very low interest rates and invest those funds
in higher yielding instruments such as US Treasuries. In the
process yen are sold and dollars are bought. That keeps the
yen exchange rate low relative to the dollar, especially in
light of the US trade deficit with Japan.
Higher Japanese interest rates would kill the
yen carry trade and could even cause some of those positions
to be unwound, since the biggest risk in the carry trade is
an increase in the yen exchange rate.
Higher Japanese interest rates do not only impact
the yen carry trade, they impact US mortgage and other interest
rates directly since funds that could have been invested in
Japanese debt instruments have instead been invested in US
debt instruments.
So while we know that the dollar will fall and
US interest rates will rise as a consequence of the US trade
and fiscal deficits when China and Japan stop supporting the
dollar, we also know that both the dollar and US bond prices
will take a hit if Japan starts raising interest rates. These
are all pieces of the same puzzle.
Expectations of a stronger yen have already
hurt the dollar. Since January the dollar has lost 1.69% against
the yen.
I mentioned earlier that the decline in the
gold price during the 1990s was due to strengthening of the
US dollar and that the increase in the gold price from 2001
to mid-2005 was due to weakening of the US dollar. However,
since about June of last year the gold price has been on a
tear that is clearly unrelated to the US dollar exchange rate.
Is it possible that players in the global financial system
were becoming aware of the impending changes in Chinese and
Japanese policy towards the dollar? Could it be that they
were positioning themselves for another, fairly dramatic decline
in the US dollar by buying gold and other instruments that
would benefit from weakness in the dollar?
My expectation is that the dollar has to decline
roughly by another 30% or so before balance can be achieved
in international trade. That decline will not be uniform against
all currencies, but will be predominantly against the renminbi,
the yen, and other Southeast Asian currencies.
Such a decline in the dollar will also cause
the dollar-gold price to rise to around $850 an ounce and
by the time this has all played out, inflation could add another
one or two hundred dollars to the gold price.
We will see.
Paul van Eeden
P.S. I will be at the Prospectors and Developers
Association conference in Toronto all of this week, so there
will not be a commentary on Friday.
P.P.S. I may in future stop publishing these
commentaries on Kitco so if you enjoy reading them I suggest
you go to my website at http://www.paulvaneeden.com/commentary.php
and register to get them by email. Rest assured that I do
not sell or rent any of my subscribers’ email addresses.
Paul van Eeden works primarily to find investments
for his own portfolio and shares his investment ideas with
subscribers to his weekly investment publication. For more
information please visit his website (www.paulvaneeden.com)
or contact his publisher at (800) 528-0559 or (602) 252-4477.
******
This letter/article is not intended to meet your specific
individual investment needs and it is not tailored to your
personal financial situation. Nothing contained herein constitutes,
is intended, or deemed to be -- either implied or otherwise
-- investment advice. This letter/article reflects the personal
views and opinions of Paul van Eeden and that is all it purports
to be. While the information herein is believed to be accurate
and reliable it is not guaranteed or implied to be so. The
information herein may not be complete or correct; it is provided
in good faith but without any legal responsibility or obligation
to provide future updates. Neither Paul van Eeden, nor anyone
else, accepts any responsibility, or assumes any liability,
whatsoever, for any direct, indirect or consequential loss
arising from the use of the information in this letter/article.
The information contained herein is subject to change without
notice, may become outdated and will not be updated. Paul
van Eeden, entities that he controls, family, friends, employees,
associates, and others may have positions in securities mentioned,
or discussed, in this letter/article. While every attempt
is made to avoid conflicts of interest, such conflicts do
arise from time to time. Whenever a conflict of interest arises,
every attempt is made to resolve such conflict in the best
possible interest of all parties, but you should not assume
that your interest would be placed ahead of anyone else’s
interest in the event of a conflict of interest. No part of
this letter/article may be reproduced, copied, emailed, faxed,
or distributed (in any form) without the express written permission
of Paul van Eeden. Everything contained herein is subject
to international copyright protection.
|
