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
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
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
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
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
As a result the gold price, in US dollars, will continue
to rise, punctuated perhaps by talk of IMF gold sales and other miscellaneous
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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