Don't jump in with both feet yet
May 28, 2004

This is a short note since I just arrived in Toronto on my way to New York for next week’s investment conference. You should try and make it to the conference if you can -- it’s going to be a great event (see sidebar for details). Admission to the conference is free if you mention that you are one of my readers when you register.

The gold price strengthened early in the week because the prevailing sentiment in the currency market was that high oil prices would hurt the Japanese economy. Currency traders who sold yen were, however, loathe to buy US dollars and settled on euros instead. This drove up the euro relative to the yen while the dollar-yen rate remained essentially unchanged. As a result the euro also gained against the US dollar. Gold traders, who have become accustomed to watching the euro-dollar exchange rate as a proxy for the dollar in general, bought gold.

It’s smart of currency traders to choose the euro above the dollar in the short term. I don’t like the euro in the long term: the European economy is not in much better shape than the US economy. But I do think that the gold market should be careful of placing too much emphasis on the euro-dollar exchange rate.

The US dollar has to, and will, devalue against the currencies of countries with which the US has the largest trade deficits. These are China, Japan and several other Southeast Asian countries, in addition to Mexico and Canada, of course. These are the exchange rates to watch, not just the euro-dollar rate. The dollar has lost about twice as much against the euro than against these currencies, on average, over the past week. Until the dollar starts to lose ground against all currencies, especially those of South East Asia, China and Japan, gold is unlikely to make its next big move.

On that basis, and because currency traders are still standing ready to bid up the dollar in anticipation of higher interest rates, I would have said that this week’s increase in the gold price was no reason to celebrate. Rather, it created a dangerous temptation for over-excited gold investors who interpret any increase in the gold price as the beginning of the next major upwards move.

But Thursday’s trading in the dollar gave me more reason to be optimistic about the gold price. Apparently currency traders now think that a modest rate increase is already priced into the current dollar-exchange rate and the uninspiring economic numbers are casting doubt over the current economic revival in the United States.

On the face of it, the dollar lost ground Thursday for the right reason: weakness in the US economy. But currency traders are still very much focused on interest rates, and they are very willing to shift capital into higher yielding denominations. This creates the risk that a higher-than-expected rate increase at the end of June could bolster the dollar and temporarily take the legs out from under the gold price.

I still maintain that we need to see the dollar weaken in the face of higher interest rates because higher interest rates will choke off any chance this economy has of averting a recession. This has not yet occurred but, as I have explained before (May 14, 2004), I believe that higher interest rates are a foregone conclusion and so are a lower dollar and a higher gold price.

So while the activity in the currency and gold markets early in the week was not based on reasons that could sustain a large increase in the gold price, Thursday’s activity was more along the lines of what I expect to see more of, and could sustain a rise in the gold price.

On balance, however, I am still not convinced that we have entered the next major upward leg in the gold bull market, and so I remain cautious. While I don’t like to see my portfolio decline, the longer the gold price takes to break out (upwards) the better the deals are going to become. I have started seeing good deals again and, as a result, I have turned from a net-seller into a net-buyer.

But I am looking for value, not exposure to the gold price -- I have plenty of that already.

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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