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It's not just interest rates that matter
August 27, 2004

Common dogma is that the dollar follows interest rates: when interest rates (such as the Federal Funds rate) increase, the dollar strengthens, and when interest rates decline, the dollar falls.

Interest rates are unlikely to decline from where they are. The Federal Funds rate is at historical lows and the budget deficit is putting real pressure on bonds, and lower bond prices mean higher interest rates.

Because the dollar follows interest rates, the dollar is expected to rise or, at worst, not decline much further. And since dollar denominated metal prices, such as gold, are inversely correlated to the dollar’s exchange rate, they are expected to be heading lower.

But if you look at the relationship between the dollar’s exchange rate and the Federal Funds rate some interesting observations can be made. The Federal Funds rate increased by more than three hundred percent from 1972 to 1974 with only a minor impact on the dollar, if any. The Federal Funds rate started soaring in 1977 but it wasn’t until about 1981 that the dollar responded. It seems then, that the Federal Funds rate can increase without causing a strengthening in the dollar. And when the dollar does respond to significantly higher interest rates, it may do so only after a lag of several years.

So could interest rates rise in the current environment without leading to a stronger dollar?

Many people make light of the trade and budget deficits of the United States. It’s understandable: their repercussions may not be felt for decades, or years, or months, so why worry?

But the dual deficits are not to be ignored; they are already influencing our investments.

The US government is running a four hundred billion dollar annual deficit that has to be financed by issuing more US Treasury bonds. An increase in bond issuances causes bond prices to fall, thereby increasing bond yields and raising interest rates. But the economy is in no shape to absorb higher interest rates.

According to the Census Bureau the number of Americans living in poverty increased by 1.3 million last year and the number of Americans without health insurance increased by 1.4 million. It was the third annual increase for both categories. There are now 35.8 million people living under the poverty line (12.5% of the population) and 45 million people without health insurance (15.6%).

If the percentage of people living in poverty increases, the number of consumers who can spend us out of a recession diminishes. And ditto for those without health insurance. Do you really think that a family without health insurance is going to buy a new SUV every couple of years?

Of course, most Americans are feeling wealthy because of their inflated home equity. House prices are still at obscene levels, especially in certain areas of California.

But in California the median price of homes declined 1.1% in July, compared to June, and real estate agents found themselves with an increasing amount of inventory. Overall, existing home sales declined 2.9% from June to July. Could that be because interest rates and mortgage rates are rising?

About two thirds of US economic activity is due to consumer spending. Higher interest rates not only increase the cost of living, they could also precipitate a decline in house prices, seriously hurting the economy: many people will “all of a sudden” feel a lot poorer. And people who are worried about money don’t spend as much as those who feel wealthy.

Thus higher interest rates can cause serious damage to the US economy, which is why many believe interest rates will not rise significantly from where they are.

Consider, however, that the US government currently has $4.3 trillion in debt that is held by the public (including foreign governments). That means the current government deficit of roughly four hundred billion will add nine percent to the outstanding debt this year and because of the War on Terrorism the deficit is likely to grow, and it has to be financed by selling more debt. That is why the budget deficit is having an impact on our investments.

The budget deficit is already causing interest rates in the US to rise. As long as the deficit continues to grow, interest rates will continue to rise, whether the economy can handle it, or not.

Now, when the economy slows down as interest rates rise, as the economy inevitably will, then the trade deficit will come into play.

The trade deficit requires almost seven hundred billion dollars of foreign investment in the US each year. These investments are mainly the purchase of government debt by the Japanese, Chinese and British governments. But they are not the only ones buying US debt: private foreign investors are also contributing and price is set on the margin. That means that when the US economy is no longer attractive to those private investors the US dollar can decline even if there is no decline in the purchases of US treasuries from the governments that are supporting the dollar.

So can we really say that the dollar, and by extension, the gold price, is solely dependent on the Federal Funds rate? I think not. I also think that ignoring the dual deficits is a mistake since they both are, and will continue to be, of paramount importance to our investments.

This is an election year so I expect the market to be unfocused and directionless. But next year is a different story. I would be surprised if the dollar were higher by the end of next year, which is another way of saying I would be surprised if the gold price were lower.

Paul van Eeden

PS Don’t forget the Las Vegas investment conference coming up next month. It will be held at the Mirage Hotel on September 8th and 9th. Please register at www.iiconf.com, and don’t forget to also register for my workshop on the morning of the 9th. I look forward to seeing you there.

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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