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
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,
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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