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
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
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