Gold Price Says U.S. Monetary and Fiscal Policy Stinks

The Fed’s been carrying on with its wayward monetary policy. And it’s carried on with the carry trade by keeping short-term rates low.

In deciding to make hardly any changes to its interest rate policy or even the language from its last statement, the Fed is encouraging traders to resume the dollar carry trade. For now, it looks safe to borrow in low-yielding currencies like the U.S. dollar and invest in higher-yielding assets like the Australian dollar, emerging market stocks, and some bonds.

Go, you bubble beauties!

It’s hard to believe the Fed is willfully stupid. The market, through the price of gold, has clearly communicated that it thinks U.S. monetary and fiscal policy is lousy. But rather than defend the U.S. dollar – indeed the integrity of U.S. monetary policy itself – the Fed is choosing to support asset prices through easy credit.

It’s also possible that the Fed thinks a weak dollar will reduce America’s trade deficit, boost its export competitiveness, and lead to higher employment. We think this is a pipe dream. And we’re not talking about a lead pipe. We’re talking William Blake-style opium.

But smoke and mirrors aside, does this mean there will be no end to the dollar carry trade? If the U.S. dollar index rallied, we expected to see a falling Aussie dollar, falling Aussie stocks, and (even though it’s strange) rising U.S. bond prices. All the leveraged risk trades would unwind a bit as dollar shorts covered.

But now what? Is this the all clear for stock indices to make new highs as traders borrow money and plow it into markets to engineer huge returns for the end-of-year statements to investors? The early returns are inconclusive. The Dow was all over the shop, unable to make heads or tails of what the Fed’s non-change means. Gold futures made a new nigh, though. And about that…

Gold is very popular lately. It’s not returning our calls anymore. And when we see it in public, all it does is glitter and bask in the glow of so many newfound admirers. That makes us very nervous, and perhaps a bit hurt. We stood by it all those years when no one loved it.

We like it all the same, although we’re just friends now and it’s based on gold’s ability to preserve the purchasing power of our wealth, not any inherent beauty it may or may not have. But as a practical matter, when you enter a position as the asset is making a new high, you usually get hammered.

That’s what happens when you go along with the crowd. It’s an axiom that an asset has to make new highs…to make new highs. But it would be nice to buy gold on a correction. Perhaps, though, we are seeing a big shift in market psychology with respect to gold. India’s purchase of IMF gold is just one sign of that shift.

One interesting result from the events of 2009, Murray Dawes mentioned last week, is that gold is decoupling from the U.S. dollar. He sent over the chart below. It shows that two times in the last five years, gold (the black line) has strengthened eve as the U.S. dollar index (the blue line) rallied. And each time after this period of dollar strength, gold then took off to a new move up.

Why does that matter? Well, gold usually moves up when the U.S. dollar moves up, and down when the U.S. dollar moves up. For gold to show strength when the dollar is strong shows that gold itself may be breaking out of its correlation to the greenback. And what would that tell you?

The bigger picture: gold breaking its negative correlation with the USD would tell you that gold is being remonetized in the world financial system. It would tell you gold is appreciating against nearly all paper currencies. And it would tell you that even if we do see a U.S. dollar rally, you could still new highs in the gold price.

Above all, it shows you how valuable it is to own an asset that is not anyone else’s liability. We are entering a global sovereign debt crisis because the world’s large economies have been engaged in a multi-decade long competition to devalue their currencies. The cheaper your currency is relative to your trading partners, the cheaper your goods are and the higher your exports.

Overly the last fifty years, nearly every country in the world has engaged in some kind of currency manipulation to keep its currency cheap relative to the American dollar. That’s because the American economy was the world’s largest, and everyone wanted to sell into it.

America’s economy is still big, of course. But a lot is changing, yet the currency manipulation has not caught up with the new economy reality. And Western Welfare states are still borrowing money as if emerging market creditors will be happy to fund fundamentally flawed fiscal policies for ever. Not likely. But tomorrow is another day.

Dan Denning
The Daily Reckoning Australia

November 10, 2009

Editor’s Note: This article originally appeared in The Daily Reckoning Australia as “Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy.” To view the original article, please click here.