Sunday, October 17, 2010

Will The Gold, Silver, Oil & Other Markets Tolerate a Lower Dollar?

15 October 2010

The plight of the U.S.

Fed Chairman Ben Bernanke said he thought the current high unemployment and low inflation environment would linger into 2011 and as a result there is a "case for further action" on the monetary policy front. Mr. Bernanke said the Fed might expand its holdings of longer-term securities. He also said that the Fed has little experience in judging the economic effects of more asset purchases. This tells us that we are stepping off into new territory. The same will be true of the rest of the world. It signals that the dollar will fall lower and probably substantially lower. $1.50 to $1.70 to the euro is on the cards. The Yen, the Swiss Franc and the Pound Sterling and just about all other currencies will try to follow the dollar down. This isn't just a 'pebble in the pond", but a great big boulder. The 'ripples will start over this weekend if not today already. They will hit every market there is.


The U.S. dollar is the globe's sole reserve currency. It is responsible for pricing virtually everything that is traded internationally. It has been relied on to price and value every item we buy. Now that the Fed and the Treasury are indicating they will debauch the dollar in the interests of resuscitating the U.S. economy, what choice do other nations have with their currencies? Most nations including China are doing all they can reasonably do to diversify away from the dollar in their reserves. The pressure is on to change the pricing of internationally traded goods to other currencies. The only other alternative is to try to sell their own currencies on the markets to lower the exchange rate. This implies importing inflation, unless they follow China's path of 'sterilization' of such through draining liquidity from their own economies. As we can see with the Yen, this is not a good road to follow because of the likelihood of attracting not just speculators but nations dumping their own dollar reserves as they diversify.

Imagine international prices being made in a selection of currencies, including emerging nation's currencies. China is already following that road. Is it possible that we see oil priced in and producers accepting, a variety of currencies? Not only would that lead to a diving dollar, but a considerable reduction in the role of the U.S. dollar. Where would these surplus dollars go, except home.

More than a declining dollar such a policy emphasizes that it's every man for himself from now on, as the U.S. cares only for its own interests. China will ask how the U.S. can point a finger its way on its currency. Other nations fear direct intervention in exchange rates as that attracts the 'carry trade' speculators. The international anger will be palpable. As we have often said, governments will always choose internal interests over external ones. The U.S. is not alone on this, so a breakdown in cooperation in the foreign exchange world will be only a symptom of the underlying fragmentation.

Capital & Exchange Controls and split Currencies:

You can see nations imposing taxes on inflows of money from Brazil to Thailand already. Watch this spread to many, many more countries now. As markets become increasingly volatile, governments and central banks will become precipitous in their imposition of defense mechanisms. We may well see measures as draconian as the split currencies that we saw in Belgium and the U.K. in the 1970's, where there was a currency for commerce and one for capital with the two being separated by a discount or premium. The main pressure this time though will be from inflows of 'hot' money [easily withdrawn capital] which can be catastrophic for an economy both when money enters and when it leaves, en masse.

So what will markets do in the face of such actions? Every market will react to compensate for the falling value of the dollar in one way or another. Equity markets will rise too, but not for good reasons.

Reactions in the Gold, Silver and Oil markets:
  • A look at the markets in the last week in these three markets has shown quick reactions to the falling dollar. All three went up, but both silver and gold went up the amount that the dollar fell. If that were to continue and the dollar to fall say to $1.70 against the euro, then without the gold price being pushed up by demand, the gold price would go up to $1,663.57 from the current $1,370. In the euro the gold price would not rise at all.
  • Silver would follow a similar path too. Technically to discount the dollar's fall alone the price would go from $24.3 to $29.51.
  • We know that O.P.E.C. members are calling for a $100 oil price to remove the impact of a falling dollar at current levels. With a $1.70: €1 dollar we should be looking much higher too.
The U.S. Balance of Payments would look great initially [except on the China account]. But internally there would be howls, as inflation took off at a rate of knots. The point made by the Fed that they don't have experience in this area worries us. They might have a tiger by the tail. When Volker shattered 25% inflation in the mid-eighties, there were very different circumstances, such as a healthy economy and undisputed dollar hegemony. The U.S. dominated the gold market - with European cooperation. This time they have none of these and such actions won't work without them!

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