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Dollar weakness and higher interest rates: how it works
February 11, 2005

For more than a year now I have been commenting that the dollar has to decline in the face of rising interest rates for the gold price (in US dollars) to sustain a meaningful rally. Every time I make that comment, someone points out that rising interest rates typically result in stronger currencies. Therefore, why would the dollar fall if interest rates are rising?

History repeats, but never exactly. While there are often precedents for current situations the circumstances are rarely identical, so we have to be careful when we make assumptions based on past experiences or events.

It is true that higher interest rates typically lead to stronger currencies, but the US balance sheet, income statement and dollar are in uncharted waters and never has globalization been as prevalent as it is now. Japan owns roughly seven hundred billion dollars worth of US Treasury securities and China has in the order of two hundred billion dollars.

Were it not for Japan and China, the US dollar would be trading a lot lower than where it is today. During the past decade the United States has racked up enormous trade deficits with those two countries. Under normal circumstances the net amount of dollars (trade deficit) paid to foreign corporations would be sold on foreign exchange markets. As the trade deficit widens, ever more dollars are sold, putting pressure on the dollar to decline. Eventually the weakening dollar would cause the prices of imported goods to rise and the rising costs of imports would ameliorate the trade deficit. This is the free market’s natural balancing system.

But Japan and China wanted to prevent their currencies from appreciating against the dollar. Put another way, they wanted to prevent the dollar from falling in response to the rising trade deficit. So instead of selling the excess dollars into the foreign exchange markets they used them to buy US Treasuries. This kept the dollars out of the foreign exchange markets and helped the US finance its budget deficits.

It was a win-win situation -- or so it seemed. The US could spend, and spend, and spend… and Japan and China would send their savings over to finance the binge. Now, however, the situation has gotten so out of hand that there is mounting pressure on China to let its currency, the renminbi, float against the dollar.

Calling for a stronger renminbi is in essence the same as calling for a weaker dollar. Now let’s go back to the mechanism that kept the renminbi, and the Japanese yen, from rising against the dollar: excess dollars were invested in US Treasuries instead of being sold into the foreign exchange markets.

If the Japanese and Chinese are to let their currencies appreciate against the dollar it also means that they will start selling more dollars into the foreign exchange markets and that means they will have less dollars to invest in US Treasuries.

This is not trivial matter. Between January and November last year, Japan and China bought about thirty percent of all the new Treasury securities the United States issued. Even a small decline in the amount of US Treasury purchases by Japan and China could have a dramatic effect on US interest rates.

If the demand for US Treasury securities (bonds) declines then bond prices are likely to decline as well. US interest rates are determined by US bond prices: if bond prices fall, interest rates rise. Therefore a decline in demand for US Treasuries from Japan and China means an increase in interest rates for the US.

Now let’s go back to the free market mechanism again. If Japan and China allow their currencies to appreciate against the dollar it also means that they will sell more of the dollars that are accumulating from the US trade deficit into the foreign exchange markets. This additional dollar-supply will result in the renminbi and yen strengthening, and the dollar weakening. It is precisely what the US and Europe are asking China to do.

So a revaluation of the renminbi will cause more dollars to be sold (downward pressure on the US dollar exchange rate) and less US Treasury securities to be purchased (downward pressure on bond prices and upward pressure on interest rates). Also, if China lets its currency appreciate then I doubt that Japan will continue to try and support the dollar by itself. So the same goes for Japan.

Now, we can argue for days and weeks about how severe the dollar decline will be, how high interest rates will go, what impact that will have on the US economy and, by extension on the global economy. The bottom line is that China will most likely allow its currency to rise this year; Japan will follow suit. That is the same as saying the dollar will continue to decline only this time against the Asian currencies as opposed to the euro and other Western currencies. And, as you saw, the decline in the dollar will occur simultaneously with rising US interest rates.

As a result the gold price, in US dollars, will continue to rise, punctuated perhaps by talk of IMF gold sales and other miscellaneous events.

This rise in the gold price, as has been the case for the past three years, is mostly a dollar phenomenon. It’s a bear market in the dollar, not a bull market in gold.

Paul van Eeden

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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