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
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
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