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The US Dollar: Over Owned and Over Valued
By John Hathaway
I invest in gold shares for a living. I manage a gold sector mutual fund. Despite this, I do not long for a return to the gold standard or wish to prescribe any particular solution for this or that
economic ill. I am not as captivated as
some by geological speculations. The
finer points of mine engineering or nifty metallurgical nuances disinterest me
unless they pertain directly to value creation in our portfolios. The painstaking bean counting necessary to
construct supply and demand models for the gold market does not dazzle me. The
promotion of gold as jewelry and the liberalization of Asian retail markets are
constructive, I suppose, but in the final analysis do little to form a
rationale for investing in the sector.
Finally, I am not caught up in conspiracy theories. None of the
foregoing considerations, it seems to me, add up to a money making proposition.
Why then, you must be asking,
would I be doing this? I see gold as a
way to reap a tidy profit on impending changes in the financial landscape. It is a speculation against financial
assets, against the preeminence of the US Dollar, and against the financial
market speculation that has raised dollar to its untenable, almighty stature.
I am only
interested because of the possibility that gold might, within a reasonable time
frame, i.e., in my lifetime, trade at $500 or even $5000/ounce. A breakout, to say $325, which we would all
enjoy, would be hardly worth the expenditure, the investment, or the time it
has taken for such a paltry result.
Gold is a potentially huge score.
What keeps me interested in this wasteland barren of investment returns
are the positive macro economic trends for gold. There are encouraging signs
that the high water mark has passed for the dollar, financial assets, and the
credit boom that has fueled the bull market in paper and the bear market in
gold.
Hedging, Derivatives, The Short Interest, and
Conspiracy
For the
most part, these considerations are ancillary to the main thrust of my
investment reasoning. However, it is
worth spending a minute or two to the extent that they can shed light on the
structure of the gold market. At best,
these factors will lead to periodic short covering rallies. By themselves, their existence will not
attract speculative capital to this arena.
The existence of a large and
vulnerable target in the form of an outsized short interest will help propel
the gold price once the dollar is under attack. Conspiracy, in my opinion, is too strong a word for what is going
on in the gold market. However, it
should surprise no one that some form of manipulation is taking place. Governments routinely intervene in the
currency markets. Gold is a form of
currency. As stated by Professor Robert
Mundell, Nobel Price Winner, “gold is subject to a lot of elements of
instability, not the least of which is the attempt on the part of several big
governments to make it unstable.”
Mundell made these comments at the World Gold Council’s 1999 Fall
Symposium in Paris, at which he was the honored guest.
Since World War II, various
governments, and especially the United States, have steadily moved in the
direction of marginalizing gold as a
reserve asset. At different points in
time, these efforts have been coordinated among several governments, although
the motivations among the various participants have not always been
consonant. The first notable example of
such activity was the London Gold Pool, a joint effort by the United States and
several European governments to depress the free market price of gold to
disguise the growing weakness of the US dollar. This effort lasted over a decade, from the mid 1950’s to
1968. At no time during the pool’s operations was there any advance
official acknowledgement that such operations were being conducted. Market players were kept in the dark. However,
speculators were able to infer the pool’s existence from the price
behavior of gold, figures on US gold reserve assets, and the balance of
payments. As a result of the pool’s
activities, substantial economic interests arose which would win or lose
depending on its success in depressing the gold price. As time passed, the incentives of all
participants to keep the free market price of gold at $35/oz diverged, most
notably France. Once national economic
interests diverged, increasing flows of speculative capital mobilized and
ultimately defeated the government scheme.
Fortunes were made at the expense of taxpayers, especially US taxpayers.
Since the early days of the
Clinton administration, the tradition of manipulating the free market gold
price has been honored. As with the
gold pool, the actual origins are probably obscure. While far more complex, current Anglo-American led efforts to
depress the price have one very important similarity to the gold pool. The financial stakes of public and private
market participants are huge. These
interests extend well beyond the immediate gold market.
There is no better illustration
than the panic in government and private circles that was touched off by the
Washington Agreement. Central bank
officials appeared to be clueless as to the structure of the gold market,
especially as to the size and location of the short position that had been
required to keep the gold price locked in a downtrend. They were horrified by the volatility of the
gold price in the following days, and of the potential damage to bullion
dealers, many of whom were also major international banks (see “JP
Morgan To The Rescue?” for more detail).
The crisis galvanized the central banking community into quick action to
provide liquidity for the gold market, which was about to vaporize. The provision of liquidity in the moment of
crisis emboldened dealers to expand positions.
As noted by Reginald Howe (The Golden Sextant), the mysterious Exchange
Stabilization Fund, managed by the US Treasury, lost $1.6 billion during the 4th
calendar quarter, more than it earned in all of 1999. After this near death experience, it is likely the official
sector’s resolve to keep gold in the deep freeze was reinforced. The continuing expansion of dealer
derivative positions despite declining producer hedging, and especially the
lengthening of maturities reported in the BIS and OCC numbers, suggest renewed
conviction among dealers that divine assistance will never be too far away in
time or price.
At the same time, the Washington
Agreement marks a watershed for the gold market. Even though central bankers worked together to end the crisis,
the interests of the Europeans and the Anglo/American camps with respect to
gold may have started to diverge. This
is despite the fact that Europeans bankers continue to be persuaded by bullion
dealers into “active” management of their gold reserves, (i.e., leasing and
dispositions to invest in interest bearing securities including, Euro
denominated.) It is also despite the
fact the US and Britain were signatories to the agreement, an act they may have
found distasteful. The Agreement marks
the first step towards the reinstatement of gold as a monetary reserve
asset. If the Euro continues to have
problems, the Europeans will figure out that there is little advantage to
trashing their largest reserve asset other than dollars. Professor Mundell has suggested that the
European Central Banks issue gold coins as part of this current
intervention: “The production of a gold
currency would heighten general interest in the euro and at the same time put
the EU’s excess gold reserves to good use.”
At the end of the day, these
structural considerations are interesting for two reasons. First, they are necessary to understand what
has already transpired in the gold market.
More important, they shed light on the massive misallocation of
investment capital. The continued
existence of a large short interest, which is impossible to cover other than
from longer term deliveries from new mine production or official sector sales,
increases the potential upside move in gold.
The Clinton
Dollar
The case for renewed investment
interest in gold centers on the proposition that the US dollar is at or near
its peak. Should this be the case,
investment flows will seek out alternatives, including gold. The dollar is the unrivaled instrument of
international credit and capital flows.
It is the foundation for most commercial and financial market
transactions. The perception that the
dollar is a store of value as well as a medium of exchange explains the
willingness of governments, businesses and individuals worldwide to hold dollar
instruments to the near exclusion of alternatives. However, it was not always so.
During the early 1960’s, 1970’s
and 1980’s, the US dollar was suspect.
In the 1960’s, the most obvious flaw was a deteriorating balance of payments
position. Other indicators such as
inflation, interest rates, and equity markets were favorable or benign. The geopolitical situation, however, was
dicey. It was not entirely clear that
capitalism and the US would ultimately prevail over the competing forces of
communism and the Soviet bloc. The gold
pool attempted to disguise the dollar’s chronic weakness by depressing the free
market price of gold.
In complete contrast, the
Clinton/Rubin/Summers dollar is beyond reproach and is almost universally
admired. At the recent Financial Times
gold conference in June, central bankers openly worried about the future of
gold, but never voiced concern as to their potentially imprudent concentration
in US dollars. The possibility that US
budget surpluses would shrink the supply of government debt was openly mourned,
despite the fact that OMB projections show no such shrinkage. These projections, found on the OMB web
site, show government debt increasing in every year through 2012, as far out as
the projections go. Still, the rage
among these seemingly ill informed central bankers is a pronounced preference
for interest earning paper assets to stagnant bars of bullion. And the preferred paper asset by far is the
US Dollar, which represents 77.7% of world central bank reserves, according to
the latest BIS annual report. The
percentage is certainly disproportionate to the US share of world trade and
economic activity.
The US trade deficit will reach
4.3% of GDP this year, as noted in a paper (Perspectives on OECD Economic
Integration: Implications for US Current Account Adjustment) presented to world
central bankers at the annual Jackson Hole symposium by Professors Obstfeld and
Rogoff. More important is the percentage
of US financial assets held abroad, $1.9 trillion or nearly 20% on a net basis
of GDP, the highest since the 1800’s.
They argue that only a small percentage of GDP is “tradable”, the
remainder being explained by non-tradable components of GDP such as rent,
transportation, labor etc. The percentage
of GDP that is internationally traded, or readily redeemable for dollars held
abroad, may only be 20% to 25% of the total, suggesting a higher rate of
borrowing and a lower degree of national solvency than is generally perceived. According to the professors, “a critical
issue in determining sustainability is not simply the rate of borrowing, but
accumulated debt.” They assess the
risks of a dollar crash as significant.
While not predicting such an outcome, the study suggests that a sudden
depreciation of 24%-40% could occur if foreigners moved quickly to exchange
their dollars.
The disproportionate ownership of
the dollar is widespread throughout numerous asset classes. According to Bridgewater Daily Observations,
gross foreign ownership of US assets now measures over $6.4 trillion (66% of
GDP). Foreigners own a record 38% of
the US treasury market, and 44% excluding Federal Reserve holdings. They own a record 20% of the US corporate
bond market and 8% of the US equity market.
What would a change of sentiment on the dollar do to US asset prices?
Keep in mind that the dollar’s
strength is only relative to the Euro and the Yen, two seemingly unappealing
alternatives. Neither has been regarded
as a serious rival, with their shortcomings widely publicized. The integration of world financial markets
has eliminated many of the traditional safe havens such as the d-mark or the
Swiss franc. World capital flows dwarf
even the more liquid currencies. It
seems as if it has come down to the dollar or nothing at all. Nothing at all, except for gold, which
stands to become the protest vote on the monetary ballot, the equivalent of
“none of the above.”
The epic strength of the dollar
is no longer something to celebrate.
The weakness of the Euro in particular has created sufficient discomfort
to trigger a round of concerted multinational intervention. The interdependence
of world economies and financial markets means that the dollar cannot be
isolated or insulated. Whenever the foreign exchange markets force the hand of
central bankers, there is reason for us to cheer. Interventions rarely work in the long term. Perhaps the Euro will be viable, but there
is no precedent for a successful multinational currency. It was the prospect of the Euro in large
part that led European central bankers to view their reserve assets, especially
gold, as redundant.
It is possible that the Euro will
turn out to be a fiasco, notwithstanding the current rescue effort. Even though the economic fundamentals of
Europe are improving, that does not assure success for this experimental,
peculiar currency. The ECB is issuing
Euros at growth rate of 10% on a 12 month basis and nearly 20% in recent
months. Banana republic growth rates
may help explain the market’s aversion.
An eventual abandonment of the Euro would be bullish for gold and
possibly bearish for the dollar, but the demise of the Euro is not the only
potential source of renewed investment interest for the metal. Time and space will not permit me than to do
more than merely mention some others:
-banking derivatives. The potential miscalculations in the gold
market are minuscule compared to the bets that have been placed on the foreign
exchange and interest rate markets.
According to the BIS, total derivatives on interest rates and currencies
measure in the hundreds of trillions.
-under investment in the
commodity sector will lead to shortages and spiraling prices in certain
commodities. What is happening in oil
is a template for nearly all other basic resources. A softening economy, favored by the bond vigilantes, will only
starve the resource sector of the necessary capital investment to meet growing
demand. The rise in commodity prices
over the past year is not a fluke.
-excessive investment in the high
tech and telecommunications sectors will lead to banking and bad loan problems
reminiscent of tanker loans, S&L defaults, real estate, and other similar
misadventures.
-the doctrine of just in time
inventory management has resulted in a run down of critical stocks of basic
materials. Supply shocks will evoke
consumer responses similar to that recently witnessed in Europe during the
protests over high energy prices. If
the markets lose their confidence in deliverability, there could be a secular
swing towards restocking and hoarding.
-the over concentration in US
financial assets. Recent acquisitions
of behemoth financial institutions by their foreign counterparts are another
sign of a market peak for financial assets.
-a recession would undoubtedly
trigger renewed monetary ease, including lower interest rates and more rapid
money growth.
-US equity prices seem to have
peaked out, with no new highs in the DJII, S&P, and NASDAQ Composite since
the first quarter of this year. Most
stocks peaked out a year or more before the averages.
-a bear market or a recession
would depress tax revenues and undermine the outlook for a budget surplus.
The dollar is potentially
vulnerable on these and many other fronts.
It is vulnerable, because like an overvalued growth stock, it is priced
for perfection. It is vulnerable,
because like an overvalued growth stock, it is over owned. The inflation news cannot remain rosy
forever. The BLS reports on the CPI and
PPI are already viewed with suspicion.
The concept of a core inflation rate has become laughable. The idea that inflationary threats can be
stifled by high interest rates, restrictive money growth, and tight fiscal
policies seems questionable against today’s political and even geopolitical
realities. The productivity myth rests
on the dubious foundation of hedonic pricing methods, a methodology applied to
the BLS price indices at the beginning of the Clinton administration. Even the Deutsche Bundesbank and OECD have
recently challenged the validity of this centerpiece of financial market
lore. Using this methodology, the BLS
has inflated spending of $28 billion by business on computer hardware, or 3% of
nominal GDP growth, to $127 billion or 20% (Richebacher Letter-Sept.2000) The impact of these adjustments is a
substantial overstatement of productivity figures and an understatement of
consumer price inflation.
The policies and practices of the Clinton Administration’s
Treasury department have established the dollar as the premier currency. This exceptional high standing is essential
to the low inflation rate enjoyed in the US but not in the rest of the
world. A weaker dollar would hinder the
access of the American consumer to
cheap foreign items and therefore lead to higher inflation.
The dollar is high because of a
successful and widespread campaign across a number of fronts and the confluence
of external events that included:
-implementation of hedonic
pricing methodology to BLS statistics.
-widespread financial market
reforms that encouraged banking industry consolidation and the emergence of
financial institutions of unprecedented scale .
-removal of trade barriers
-curtailment of longer term
treasury debt maturities
-endless spin on a strong dollar
-making sure gold did not
establish an uptrend.
-the demise of the Soviet empire.
-the strong fiscal position of
the US
There
were probably a number of other contributors to this strong dollar policy. These developments interacted with the
markets in a way that reinforced the dollar’s strength and undermined gold. However these measures and/or events, like
the Clinton administration, will soon be history. The explanations are similar to those associated with great
growth stocks at their peak valuations.
They are easy to articulate in retrospect, and there is a tendency by
market participants to extrapolate more of the same. However, we may have reached the limits of the desirability of a
strong dollar based on the extreme position of our trade balance and foreign
asset ownership. The Euro intervention
is a tip off that there is sufficient disquiet in the public and private sector
that a change is in the wind.
The real
clues to the outlook for gold lie in the market for the US dollar. The Clinton administration’s strong dollar campaign
has enjoyed wild success, creating an insatiable appetite for the paper. This success is a principal reason for the
dollar’s present vulnerability. When
will foreign holders of US assets begin to suffer from buyers’ remorse and
realize that the strong dollar has gone too far? The fundamentals supporting a change of opinion have been in
place for some time and without a catalyst could continue. Identifying a particular catalyst is very
tricky, but there seems little doubt that prospects for a change of direction
are promising.
John Hathaway
Mr. Hathaway is a Senior Portfolio Manager at Tocqueville Asset
Management L.P. and portfolio manager of The Tocqueville Gold
Fund. http://www.tocqueville.com/funds/tgold.htm
