September 23, 2005
The beauty of being a long-term investor -- as opposed to
a short term trader -- is that I can take my eyes off my computer screen
for more than fifteen minutes without experiencing an anxiety attack.
September has been a hectic month thus far with a conference in Las Vegas,
one in Deer Lake Newfoundland, the Denver Gold Forum coming up next week
and the Toronto Investment Conference shortly thereafter. I have spent
very little time at home and far too much at airports and hotels, which
is why these commentaries have been scarce lately. But, as I said, being
in the market for the long term has its benefits: the fact that I did
not have time to analyze each day’s change in the gold price caused
me no discomfort whatsoever.
We all know that the US is in the midst of a real estate
bubble, however, home construction fell for the second month a row and
permits for new buildings also declined in August. The National Association
of Home Builders’ index for sales of new, single family homes fell
in September indicating a decline in sentiment among US home builders.
Freddie Mac also reported that 30-year fixed mortgage rates are on the
rise again and the supply of new houses for sale is increasing, in other
words the houses are not selling as fast as builders anticipated. At the
same time the median price for a new home fell in July. Could the real
estate market be showing signs of a top?
Although less discussed, both bonds and equities are at
lofty levels as well. Predicting the exact time when a bubble will burst
is impossible, unless you’re just lucky, and so we will only know
in hindsight when the turning point occurred. But with all that’s
going on, the risk of staying in the stock market, owning long-term bonds,
and speculating on real estate seems just plain stupid.
Now let’s look at the Federal Reserve Board’s
actions of late within the context of these risks. This week the Fed raised
the overnight rate for the eleventh consecutive time. Officially, the
Fed says that the risk of inflation is greater than the risk of hurting
the economy by raising short-term interest rates. But the market disagrees
and buys bonds, which is why long-term interest rates have been falling
even though the Fed has been raising the overnight rate. Since Katrina,
however, long-term interest rates have been on the rise. This could be
seen as a harbinger of inflation as the country attempts to cope with
rebuilding a city and the impact that higher gasoline prices will have
on the economy and prices.
So the Fed is worried about inflation. But which inflation?
Are they worried about the increase in the money supply or are they worried
that higher gasoline prices will ultimately lead to higher consumer prices?
Remember, inflation is an increase in money supply that can lead to an
increase in prices. An increase in prices is, by itself, not inflation.
So if the gasoline price rises because a hurricane shuts down production
that is not inflation. Similarly, if the price of oil goes up because
the US dollar fell on foreign exchange markets, it is not inflation.
Surely the Fed has to be concerned that its policy of raising
interest rates could hurt the US economy by deflating the real estate
bubble and slowing economic growth. In fact, the abuse of leverage in
the US real estate market and the extent to which consumers, corporations,
and the government itself, are indebted should raise the risk of a deflationary
collapse if interest rates keep rising. Especially if long-term interest
rates start rising as well, which it appears they may have started doing.
So how can the
Fed justify its policy of increasing interest rates?
According to the Fed its policy is to raise interest rates
to a neutral position -- the interest rate at which economic growth is
neither promoted nor hindered. Currently, the Fed believes that interest
rates are still promoting economic growth, in other words, interest rates
are too low. How does the Fed know what interest rate is optimal? It doesn’t.
The Fed doesn’t even know what money is! Alan Greenspan admitted
that crafting monetary policy is problematic because the Federal Reserve
does not know how to define money or how to measure it. If the Fed cannot
even define, never mind measure, what money is, how can it possibly be
so sure that it knows the optimal interest rate at which the economy is
neither hindered nor stimulated?
I suspect that the Federal Reserve Board Governors know
they have a problem. Could it be that they are worried about something
much larger than the devastation caused by Katrina, the impact of higher
gasoline prices on consumer spending or a slowdown in real estate spending
due to higher interest rates?
The US consumption binge, from stocks, bonds and real estate
to the money we spend in our malls on credit cards, is being financed
by foreign capital. Cut off the influx of foreign capital and you basically
switch off the life support of a terminally ill US economy. Sustaining
foreign appetite for US financial products is arguably far more important
than anything else affecting the US economy at the moment.
Now, if the US dollar were to decline on foreign exchange
markets then foreign investors could start losing money on their US investments
even if their US investments are not losing money in US dollar terms.
And if US investment returns go south then the losses to foreign investors
A falling US dollar would also stoke an increase in prices
and, if you (erroneously) think that higher prices means inflation, then
you could say that a falling US dollar will lead to inflation. Is it possible
that underlying the Fed’s preoccupation with inflation is really
a concern about the dollar?
During the past year or so the relationship between the
US dollar gold price and the US dollar exchange rate has become more widely
accepted. Yes, I know that some people think the gold price is becoming
disconnected from the US dollar but… it’s not. As more and
more investors and, especially institutional investors, realize that they
can play the dollar exchange rate by going long (or short) gold, the gold
price becomes more volatile. The gold price may also from time to time
move in patterns not predicted by the dollar exchange rate as investors
establish (or dissolve) positions in anticipation of a move in the dollar
Take this past week as an example. The dollar rallied both
in anticipation of a further increase in interest rates and in response
to the German elections. But the gold price rallied alongside the dollar.
Now, could it be that the gold price was rallying in anticipation of a
decline in the dollar once the initial rally is over? Certainly if we
look at Wednesday’s and Thursday’s activity it will confirm
that the gold-dollar relationship is still intact. On Wednesday the dollar
fell and gold rallied; on Thursday the dollar rallied and gold fell. Ditto
on Friday. The question is, what happened prior to Wednesday.
One possibility is that long gold positions were being
established in anticipation of a future decline in the dollar. Another
is that short positions were being covered creating temporary demand.
Either way, it seems to me that short term trading merely obscured the
relationship between the US dollar gold price and the US dollar exchange
rate that has by now been well established.
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 investment publication. For more information please visit
his website (www.paulvaneeden.com)
or contact his publisher at (800) 528-0559 or (602) 252-4477.
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.
This letter/article is not intended to meet your specific individual investment
needs and it is not tailored to your personal financial situation. Nothing contained
herein constitutes, is intended, or deemed to be -- either implied or otherwise
-- investment advice. This letter/article reflects the personal views and opinions
of Paul van Eeden and that is all it purports to be. While the information herein
is believed to be accurate and reliable it is not guaranteed or implied to be
so. The information herein may not be complete or correct; it is provided in
good faith but without any legal responsibility or obligation to provide future
updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility,
or assumes any liability, whatsoever, for any direct, indirect or consequential
loss arising from the use of the information in this letter/article. The information
contained herein is subject to change without notice, may become outdated and
will not be updated. Paul van Eeden, entities that he controls, family, friends,
employees, associates, and others may have positions in securities mentioned,
or discussed, in this letter/article. While every attempt is made to avoid conflicts
of interest, such conflicts do arise from time to time. Whenever a conflict
of interest arises, every attempt is made to resolve such conflict in the best
possible interest of all parties, but you should not assume that your interest
would be placed ahead of anyone else’s interest in the event of a conflict
of interest. No part of this letter/article may be reproduced, copied, emailed,
faxed, or distributed (in any form) without the express written permission of
Paul van Eeden. Everything contained herein is subject to international copyright