King Dollar at the Guillotine

Whither the dollar? Downwards, of course. The U.S. trade deficit continues to rise. It is well over 5% of GDP and going to 6%, and such levels normally mean a serious correction in the value of a currency. But while the dollar has dropped, especially against the euro, it has not dropped as much as you might think on a trade-weighted basis.

The dollar is doing better than it should because China has fixed its currency to the dollar, and the rest of Asia is in a competitive currency devaluation race to see who can make their currency lower in order to attract U.S. consumers. The world and especially Asia will continue to be addicted to the U.S. consumer. They sell us their products for electronic dollars, and then buy our government paper and stock. The world either owns 35% (BCA Research) or 42% (Morgan Stanley) of our Treasury debt. Morgan Stanley also reports foreign investors own 18% of U.S. long-term securities and stocks.

Why would foreign central banks continue to buy and hold large positions of dollar-denominated U.S. assets when it is clear the dollar is over-priced? Because they have a Hobson’s choice: they can take pain now or take it later. Politicians are the same all over the world…they all prefer to take their pain later, even if it will be more severe.

If a country stops taking dollars and buying U.S. assets, then its currency will rise and make its products less attractive to American consumers. In export-driven economies, this is a disaster, especially for the politicians, as it assures a recession at the very least. Thus, foreigners continue to support the great American spending habit.

Floating the Renminbi: A Sideways and Downwards Ballet

Gary Shilling’s INSIGHT newsletter reports that Canada, Mexico, China and Japan account for 47% of the trade- weighted currencies. The Canuck is flat for the year, the peso is actually down 10% and the yen is down more than 10% for the year, much to the consternation of the Bank of Japan. The Chinese currency is pegged to the dollar, so there has been no movement there. In other words, these currencies have all been moving in tandem to the rhythm of a sideways-and-downwards ballet.

Thus, the dollar’s drop against the euro is the single major reason the dollar has dropped slightly on a trade- weighted basis, when seen on multi-decade chart.

Is there a limit to this? Of course. The U.S. can’t sell more than 100% of its assets, and it is now selling $500 billion a year. At this rate, the rest of the world will own 100% of U.S. government debt in ten years, even as America grows its deficits. Clearly this is not sustainable.

When does the pain of taking over-valued dollars become more than the pain of selling less to the U.S.? I think it is when China allows its currency to float. Asian countries do not necessarily want an over-priced dollar; they simply want the price of their currencies to be favorable in relation to their neighbors. China is the gorilla in this process: when they allow the renminbi to rise, the rest of Asia will feel comfortable letting their currencies rise as well. That will be the real end of the dollar.

Interestingly, there is an increasing call from many corners of the world for the Chinese to allow the renminbi to float. China has not responded to the pressure, but as do all countries, it will act when it feels to do so is in its own best interests. That will probably be when the Chinese find that their own consumer demand is growing and solid, and thus can sustain a possible slowing of sales to the U.S. When that will be is anyone’s guess…and so the dollar might remain surprisingly strong even when, by all rights, it ought to drop. But China’s decision to act on the renminbi could be the surprise move that sets this set of dominoes in motion.

Floating the Renminbi: Letting the Dollar Drop

Europe is the one real exception to foreign support of the dollar. The European Central Bank seems quite content to let the dollar drop. And despite the weakness in Europe, I think it is likely this trend will continue.

From its current position at 1.069, the “natural” target of the next 12-18 months, if not sooner, is around $1.17, which is where the euro started about four years ago. Europe will probably resist a drop much further than $1.17…until China starts the dollar tumbling down the hill so it can stay competitive as well. It is truly every country for themselves in the currency markets.

This naturally brings us to that international currency: gold.

Gold has finally gotten off the floor. It has become the hot investment of the year, up around 30% in 2002, depending upon which day you look. I think it has more room on the upside.

Central banks are not in some vast conspiracy to hold down the price of gold. They simply want to sell what they have. They do not understand the yellow stuff, and don’t want to own it. As gold rises, they will sell more. They prefer electrons to hard metal, which in theory can earn interest.

My long-held belief is that gold acts like a currency, and if the dollar drops another 10% against the euro, you could easily see another 10% rise in gold. Because gold is so thin a market, it could rise much further fairly quickly, if central banks decide to limit their sales.

When the need of central bankers coincides with the direction of the market, we should pay attention. Yes, the dollar might not accelerate its descent just yet…but there is no question that it ought to. Thus, I continue to be a fan of gold and gold stocks in the long term.


John Mauldin
for the Daily Reckoning
January 22, 2003


Sell stocks; buy gold. The Trade of the Decade has been a big winner for the last 3 years. And stocks were down again yesterday; gold was up.

Whether it will continue to be a big winner or not, we can’t say. But we wouldn’t give up on it yet. Stocks are still much too expensive. And gold – though perhaps overbought in the short term – is still far too cheap.

Abby Joseph Cohen says you should have 75% of your money in stocks. Ed Kerschner, Steve Galbraith and other Wall Street strategists agree, with Kerschner recommending an 89% exposure to the stock market. Of course, the companies they work for sell stock, but we’re sure that does not affect their judgment. They call them as they see them – and right now, they see rising stock prices.

It will be a long time before the lumpeninvestoriat gives up on the dream of getting rich without working. That’s the promise of modern American capitalism…that even ordinary people can “make money while they sleep,” to use Francois Mitterand’s expression. Wall Street forgot to mention that they could lose money while they sleep, too.

Except for China, the world economy seems to be drifting into an era of slow growth, deflation, and stock market losses. Europe, North America and Japan all have aging populations and feeble economies. Everybody depends on U.S. consumers to keep buying…but the Americans are running out of money. For 30 years they’ve been consuming more and more of their savings, instead of investing it on worthwhile projects. They have jobs – but the jobs don’t pay much better than they did 30 years ago. And the consumer has much more debt than ever before. The Fed offers to make more and more money available – but what are Americans going to do with it? They’re already having trouble paying their bills. Why would they want to borrow more? And businesses, what can they do? The heyday of mergers and acquisitions, stock buybacks, and huge investments in information technology is over. With consumer goods falling in price, it’s very hard to find capital investment projects that will make a profit – no matter how low the Fed puts short-term rates. Business profits, as we have pointed out before, have been declining as a percentage of GDP for the last 30 years.

China is not complaining. It has the lowest labor rates in the world and a remarkably dynamic manufacturing sector. Its people save 25% of their incomes (the most recent figure for Americans was less than 2%) and has linked its currency to the dollar, so a falling greenback makes Chinese goods even more competitive. Other nations will have to lower their currencies too, in order to avoid losing market share.

And so…we have the wonderful, wacky, world of 2003, with a falling dollar…falling stock prices…a little deflation, a little inflation…and rising gold.

Sit back, relax…it may be with us for a long, long time.

What’s new in the Big Apple, Eric?


Eric Fry in New York…

– The stock market’s promising January rally is rapidly running out of gas, as the Dow Jones Industrial Average sputtered for a fourth straight day. The blue chips dropped 144 points to 8,423, while the Nasdaq slipped 12 to 1,364. Meanwhile, the dollar’s dolorous decline continues. The greenback fell another half a percent yesterday to $1.069.

– The dollar’s weakness, of course, is gold’s strength. The yellow metal dipped more than $3 early in the New York trading session. But by lunchtime, gold had recovered its losses and moved into the plus column, gaining 70 cents to $357.50. Like an annoying party guest, gold just keeps hanging around. Most folks expected the precious metal to ‘cut out’ a long time ago. But it refuses to go away.

– The editors of the Daily Reckoning are long-time admirers of gold, mostly because we have no idea what the future holds. Given our macroeconomic agnosticism, gold seems a worthy hedge against the unknowable…But then along comes James Turk – decades-long gold bug and West Coast eccentric – to remove the scales from our eyes. Mr. Turk knows exactly where the gold price is going and when it will get there.

– Turk announced yesterday, “The gold price will hit $934 an ounce by October of 2004.” Turk’s prediction is audacious, to be sure, but we wouldn’t rule it out. Given the dollar’s persistent weakness, the gold price could surprise even mega-bulls like Turk. What’s more, the U.S. is not alone in seeking a weaker currency, and a synchronous global currency debasement could be a wonderful thing for the gold price.

– U.S. Fed Governor Ben Bernanke is not the only central banker seeking to cheapen the home crowd’s currency. Monetary authorities worldwide are hoping to weaken their currencies as a way of stimulating export growth.

– “Such are the times that few governments welcome a rising exchange rate,” James Grant explains. “Each of the three principal currency blocks – dollar, euro, yen – would welcome a falling exchange rate…Of course, the top currencies can’t all simultaneously become cheaper against each other. They can only become cheaper against an alternative. What would that alternative be? Constant readers may close their eyes, because they have read the answer here before. It is gold, an asset with the virtue of being mute. It never complains and never explains, and it has no central bank…It does not object if its price appreciates…”

– Nor do we.

– “An awful convergence of macroeconomic trends was revealed last week,” observes Strategic Investments editor, Dan Denning. “Spending for the indebted consumer went up. But business spending did not. What demand there is in America is directed towards foreign goods, with the profits going overseas, further putting pressure on U.S. firms; the very same firms who have no incentive to invest in new jobs because they are already operating well below capacity. The only real question left for the economy is when the consumer will surrender.”

– No white flags are waving just yet. To the contrary, homebuyers are still buying and homebuilders are still building, according to the latest stats from the Commerce Department. Housing starts surged 5% in December from the November level. Building permits rose an even more impressive 8.2%.

– The robust housing data spurred copper prices to a new six- month high of 76.8 cents per pound. Copper is not the only commodity that’s on a tear, of course. The CRB Index of commodity prices advanced to a fresh six-year high of 242.11 yesterday. [For more information about opportunities in commodities and natural resources, see:Outstanding Investments] Repeat after me: there is no inflation.

– “The world wants to reflate,” says Grant. “Bloomberg News reminds us that, by August, the Bank of Japan, the European Central Bank and the Bank of England will all be under new management. ‘With the 1970s inflation rates of 10% or more a distant memory,’ the news service notes, ‘the new central bankers will probably keep a lid on interest rates.'” We suspect that the new generation of central bankers will also see to it that their national mints do not lack for either parchment or pigment.


Back in Paris…there is little to report…

*** The euro is at a 3-year high – ouch! Oil is at a 2-year high.

*** The Wall Street Journal reports that Europeans are buying fewer dollar assets – 36% fewer based on October figures. America still needs huge amounts of capital from overseas to plug the gap between what its citizens spend and what they produce. Where’s the money going to come from, we keep wondering?

*** France’s Prime Minister, Jean-Pierre Raffarin, announced that the “days of running the country based on ideology are over.” From now on, says he, it’s all about getting the job done at the most reasonable price. Nobody seems to care about ideology any more. Karl Marx has joined Groucho and Chico as a comic figure. Che appears on T- shirts, worn by people who think he was a rock & roll star who died in a plane crash.

*** “Did you pay attention in school today?”

Edward’s mother posed the question at dinner. “I only turned around and talked one time,” came the answer.

Edward had been moved to a seat right in front of the teacher’s desk so she could keep an eye on him.

“But the teacher said if I kept doing better, she would give me a better report at the end of this trimester.”

The Daily Reckoning