Change is upon us
Paul van Eeden
[Editor's note: Welcome to Paul van Eeden as a contributor to 321gold.]
Longtime readers of my commentaries may recall that I have been waiting for the dollar to fall while US interest rates rise at the same time. Even though it may not be intuitive that the dollar could fall while interest rates rise, I think current events in both China and Japan are setting the stage for it to happen.
To show how significant recent announcements from both China and Japan are I am going to recap the events leading up to them. If the following is too brief, I suggest you read past commentaries on my website for more background.
Since 1992 more than four trillion dollars of foreign capital have been invested in the US. This capital influx was due to a series of currency crises, beginning with the Brazilian Real in 1992. Capital, seeking a safe haven, poured into the United States. Initially, this influx of capital caused US interest rates to fall, US corporate profits to rise and consumer spending to increase. The resultant bull market in stocks and bonds was fertile ground for investor speculation and gave rise to the high-tech, or Internet bubble. When the high-tech bubble burst, the Federal Reserve reacted by artificially driving interest rates even lower, causing a real estate bubble in the US and averting the collapse of the broader US stock market.
When the Southeast Asian currency crisis began in 1996 with the fall of the yen, the extraordinary amount of capital that flowed into the US caused an unprecedented rise in the US dollar exchange rate. This increase in the US dollar exchange rate in turn caused a decrease in the price of all things priced in dollars: oil, commodities, metals, gold and, of course, all US imports. Lower import prices in the US in turn lead to an expansion of the US trade deficit.
At the same time we also saw the emergence of China as an economic powerhouse, with a massive shift of manufacturing capacity away from North America and Europe to China. In order to maximize the benefit of the strong US dollar, both China and Japan elected not to sell the trade dollars they were receiving back into foreign exchange markets. Instead, they bought US Treasuries with those dollars.
Under normal circumstances, when a country such as Japan receives trade dollars due to its trade surplus with the United States, it sells those dollars in the foreign exchange markets. By selling dollars and buying yen, the trade imbalance would lower the exchange rate of the dollar and increase the exchange rate of the yen, thus increasing the cost of exports from Japan and increasing the cost of imports in the US, which would eventually neutralize the trade imbalance. But because both China and Japan (and several other Southeast Asian countries) withheld their trade dollars from foreign exchange markets, their export prices and US import prices were kept low. This caused an exacerbation of the US trade deficit, and it also kept US interest rates low since the bulk of those dollars were invested in US bonds.
Oil and metal prices declined precipitously during the late 1990s because of the rise in the US dollar exchange rate. Declines in metal and oil prices were far less pronounced in many other currencies and, in fact, the gold price increased in some currencies even while it was falling in US dollars. I realized during the late 1990s that the gold price (in US dollars) would not sustain a rally until we saw the end of the rise in the dollar itself. Between 1999 and 2001 the dollar rally petered out and by 2002 the dollar was entrenched in a bear market as the combination of falling interest rates in the US and the trade deficit took their toll. Oil, commodities, metals and gold prices started rising.
The increase in most metals and commodity prices were initially just a reflection of the falling US dollar exchange rate; however, because of the expansion occurring in China, among other things, some commodities and metals prices rose more than what could be accounted for by the dollar alone.
The gold price, on the other hand, was almost exactly paired to the US dollar exchange rate up to the middle of 2005.
Now we can evaluate the current situation with the twin deficits of the United States.
The US trade deficit simply means that US residents buy more imports than what they export. The net result of the trade deficit is that US dollars are being sent to other countries, and, as mentioned earlier, under normal circumstances those dollars would have been sold in foreign exchange markets, putting downward pressure on the dollar. A weaker dollar would translate into higher prices for US imports and lower prices for US exports and that would in turn cause a reduction, or elimination, of the trade imbalance. Therefore, the US trade deficit will eventually cause the US dollar to decline. The only reason it has not yet done so is because China, Japan, and several other countries are not selling their US dollars, but investing them in US Treasuries instead.
That brings us to the US fiscal deficit. A fiscal deficit arises when the government spends more than it receives from taxes. The US fiscal deficit is much larger than the budget deficit and contrary to what the media and politicians would like you to believe, the US fiscal condition is worsening, not getting better.
The current debt limit for the US government is $8.184 trillion and if that limit is not raised by the middle of the month the government will likely go into default. All it means is that lawmakers will vote to increase the debt limit. But the amount by which they will increase the debt limit is what is interesting. The current proposal is for an increase of $781 billion. Why $781 billion? Probably because that is more or less what they expect the fiscal deficit will be for the next twelve months, or so.
During fiscal 2005 (that ended on September 30, 2005) the government's debt increased by $554 billion. Since then the debt has increased by $337 billion, which, when annualized, comes to $814 billion. Don't be misled by budget deficits: politicians can budget all they like but their spendthrift ways become evident in the increase in debt.
As an aside, the current debt of $8.27 trillion does not include unfunded liabilities of the US government, such as Social Security, Medicaid and Medicare. Including unfunded liabilities the US government is approximately $46 trillion in the hole.
The fiscal deficit means the US government continually has to issue more and more debt to finance its spending and the issuance of debt means an increase in the supply of US bonds that will ultimately lead to lower bond prices and higher interest rates. This is where the trade deficit and the fiscal deficit meet. Just like the trade deficit implies the dollar will fall, the fiscal deficit will ultimately cause US interest rates to rise.
Recall that China, Japan, and others were buying US Treasury debt (bonds) with their trade dollars instead of selling those dollars into foreign exchange markets. That is what kept the dollar afloat, but it is also what kept US medium to long term interest rates so low since no matter how much more debt the government issued, these nations stood ready to buy it.
Looking at this I realized that we are going to witness an unexpected turn of events. When China and Japan decide to stop buying US Treasuries with their trade surplus dollars, the US dollar exchange rate will fall simultaneous with rising US interest rates. This is not intuitive since common dogma suggests currencies rise when interest rates rise and fall when interest rates fall. Yet I believe that the US dollar is going to fall while US interest rates rise.
You probably already figured out how this works: When China and Japan stop buying US treasuries with their trade dollars they will no longer be supporting the US government's debt issues, which means the US fiscal deficit and the resultant necessity to issue bonds will cause bond prices to fall and interest rates to rise. At the same time, China and Japan will have to do something with those dollars. My suspicion is that they will gradually start selling more and more trade dollars for their own currencies so that they can invest in their own economies.
I am not suggesting that China or Japan will start selling massive amounts of dollars that are currently held in their foreign reserve accounts, merely that they will reduce the rate at which they are accumulating US dollars in their foreign reserve accounts.
It has always been clear that China and Japan will support the US dollar only as long as it is in their interest and I have made the point that it is in their interest only while US consumption of their goods continues to grow. We have seen that US economic growth is faltering and therefore I believe we are at the end of their support of the dollar.
In December a Chinese newspaper, called The Standard, printed an article that quoted Mr. Yu Yongding, a member of the monetary policy advisory committee to the People's Bank of China, as saying that China should weaken the link between the yuan (renminbi) and the US dollar to make the exchange rate more flexible and improve the Chinese government's ability to manage their economy. Yu suggested that the weighting of the US dollar in the basket of currencies against which the renminbi is set should be reduced, thereby reducing the impact that changes in the US dollar would have on the value of the renminbi.
The next day Mr. Yu Yongding was quoted by the same newspaper as saying that Chinese firms should get ready for a strengthening of the yuan (renminbi) during the next one to two years. The "fuller the preparations, the better," he said. The same article mentions a research paper obtained by Reuters, wherein Mr. Yu Yongding suggested China could reduce the growth in its foreign reserves by running expansionary fiscal policies and investing in infrastructure and research and development.
It seems to me that China is getting ready to do exactly what I expected they would do: start selling trade dollars and investing the proceeds into the Chinese economy. But if China abandons the dollar, Japan will follow, because supporting the dollar is not possible for either China or Japan alone: it requires both of them to act in concert.
And indeed, last week we learned that Japan is considering raising interest rates. For almost ten years now Japanese interest rates have been near zero in an attempt to avoid a deflationary collapse. Such low interest rates meant little demand for Japanese bonds and hence virtually no investment demand for Japanese yen. Instead it created what is called the yen carry trade. Large investors could borrow yen at very low interest rates and invest those funds in higher yielding instruments such as US Treasuries. In the process yen are sold and dollars are bought. That keeps the yen exchange rate low relative to the dollar, especially in light of the US trade deficit with Japan.
Higher Japanese interest rates would kill the yen carry trade and could even cause some of those positions to be unwound, since the biggest risk in the carry trade is an increase in the yen exchange rate.
Higher Japanese interest rates do not only impact the yen carry trade, they impact US mortgage and other interest rates directly since funds that could have been invested in Japanese debt instruments have instead been invested in US debt instruments.
So while we know that the dollar will fall and US interest rates will rise as a consequence of the US trade and fiscal deficits when China and Japan stop supporting the dollar, we also know that both the dollar and US bond prices will take a hit if Japan starts raising interest rates. These are all pieces of the same puzzle.
Expectations of a stronger yen have already hurt the dollar. Since January the dollar has lost 1.69% against the yen.
I mentioned earlier that the decline in the gold price during the 1990s was due to strengthening of the US dollar and that the increase in the gold price from 2001 to mid-2005 was due to weakening of the US dollar. However, since about June of last year the gold price has been on a tear that is clearly unrelated to the US dollar exchange rate. Is it possible that players in the global financial system were becoming aware of the impending changes in Chinese and Japanese policy towards the dollar? Could it be that they were positioning themselves for another, fairly dramatic decline in the US dollar by buying gold and other instruments that would benefit from weakness in the dollar?
My expectation is that the dollar has to decline roughly by another 30% or so before balance can be achieved in international trade. That decline will not be uniform against all currencies, but will be predominantly against the renminbi, the yen, and other Southeast Asian currencies.
Such a decline in the dollar will also cause the dollar-gold price to rise to around $850 an ounce and by the time this has all played out, inflation could add another one or two hundred dollars to the gold price.
We will see.
-Paul van Eeden
P.S. I will be at the Prospectors and Developers Association conference in Toronto all of this week, so there will not be a commentary on Friday.
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