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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.
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