Higher interest rates and a stronger dollar
June 11, 2004

I received an email after my previous column questioning the logic of my comment that the dollar has to weaken in the face of higher interest rates. The writer pointed out that currencies strengthen when interest rates rise and, therefore, a rise in US interest rates will cause the dollar to strengthen and the gold price to decline.

I agree. If higher US interest rates continue to lift the dollar on currency markets the gold price will continue to decline. And since I believe interest rates will continue to rise as a result of the Budget Deficit, which is not going away anytime soon, we might as well declare the gold bull market over.

Actually, this is precisely what is happening at the moment and why I wrote the previous column. I don’t think the gold price is going anywhere until we see the dollar decline in spite of higher interest rates. And I do think that the dollar will decline despite higher interest rates.

Interest rates (the cost of capital) typically rise during the late stages of an expansion phase in the business cycle -- due to the increased demand for capital. Interest rates decline again when the demand for money subsides during the contraction phase. When interest rates become low enough, in other words, when capital becomes cheap enough, it stimulates the economy and helps initiate the next growth phase -- ergo the business cycle.

During the Nineties, currency crises sent capital to the United States, creating demand for dollars, US bonds and US stocks, and extending the business cycle far beyond its natural life. The result was an increase in the dollar’s exchange rate, an increase in bond prices (and therefore a decline in interest rates) and an increase in equity prices. Foreign investors made out like bandits: they made money or their US equities, bonds and on the appreciation of the dollar.

The allure of extraordinary profits drew more and more capital into the United States, boosting equities, bonds and the dollar, and the increase in these attracted even more capital. Under these circumstances interest rates were not responding to internal pressures in the economy: they actually fell in the latter stages of an economic expansion because foreign capital was bidding up bond prices.

The top in the bond market is behind us and interest rates are going up, not because of the threat of inflation, but because the Budget Deficit has to be financed by issuing bonds. This increase in the supply of bonds is driving bond prices down and interest rates up; it’s what’s been going on for the past six months.

Higher interest rates will choke the economy, arrest economic growth, collapse share prices and bring down real estate values. In turn, this will reduce government tax receipts and expand the Budget Deficit, so that even more bonds have to be issued the following year.

From now on foreign investors are going to lose money on their US equities and their US bonds, and these losses are going to be compounded with, at best, uncertainty about the dollar.

The US needs to attract in the order of five hundred billion dollars in foreign investment every year to balance the Trade Deficit. How many years of bond and equity portfolio losses will it take before foreign capital stops pouring in? And when foreign capital does stop flowing into the US, the dollar will decline.

In my opinion the belief that the United States can attract foreign capital in the order of five hundred billion dollars every year when higher interest rates decimate its fragile economy is the fallacy.

So yes, I know that currencies typically strengthen when interest rates rise, which is precisely why I wrote last week’s column. At some point, most probably after the election, we are likely to see the dollar fall in spite of higher interest rates. That is when the gold bull market will resume in earnest.

Meanwhile, use this time to position your portfolio, to make the most of higher interest rates, a lower dollar and a higher gold price.

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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