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 falls.
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
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 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, or not.
Now, when the economy slows down as interest rates rise,
as the economy inevitably will, then the trade deficit will come into
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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