The Fed's subsidization of the American economy is over. The era of cheap money is at an end. Interest rates have ratcheted up again in England, following increases in Australia and China, so the long overdue rate increase in the United States was no surprise. With interest rates at the lowest in recorded history, America's net national savings rate dropped to less than 2% of GDP as they borrowed with wild abandon. For three years, US interest rates have been in negative territory as the Americans pursued a cheap money policy. As such, further rate increases are inevitable which would expose the vulnerability of America's financial center causing a further large devaluation of the dollar. And with the election looming in the fall, a cheerleading Fed reluctantly removed the punch bowl.

Flood Of Red Ink

A For some time now we raised concerns about this environment of unsustainable low interest rates, believing that the glut of dollars would eventually feed rising prices. Record household debt together with record government twin deficits have made the US economy highly sensitive to the impact of higher interest rates. The United States is the world's biggest capital importer and net debtor. And now, even a small uptick in interest rates were enough to cause both the stock market and housing markets to swoon on concerns about the overly indebted consumer and financial institutions that financed this orgy of spending. Questions are asked of even the "too big to fail" Fannie Mae and Freddie Mac. Of more concern, is that while the consumer has retrenched, the Federal Government has not, and is still running huge budgetary deficits.

The deficits are the dollar's Achilles heel. To date, the dollar has lost 15 percent of its value. The US current account deficit widened to $145 billion in the first quarter and a record $55.8 billion in June. The current account deficit, a broad measure of how much more the US is spending than taking in, is over 5 percent of GDP rising to over half a trillion dollars. The deficit reflects the fact that Americans are spending more than they earn and their robust economy is sucking in imports at a greater pace. Under President Bush the budget has swung from a surplus to a deficit in only one term - a swing of $700 billion.

To balance its books, the US depends on the largesse of foreigners and must attract more than $2.0 billion of net investment each day to cover the current account shortfall. In the past, foreigners were piling up US assets at a huge pace led by Asian economies intervening to prevent their currencies rising further against the US dollar. In 1993, foreign holdings accounted for 20 percent of US debt today. Foreign investors own almost half or $1.75 trillion of the $3.76 trillion of marketable treasury debt.

Recent data shows overseas interest in US equities waned but after four consecutive monthly declines, purchases picked up slightly in June. Lacking the necessary pool of savings, the Americans are dependant on massive lending from the rest of the world. The monstrous US trade deficit must be matched by a corresponding surplus elsewhere.

Central banks also slowed their dollar purchases in the latest quarter and there was a collapse in demand for treasuries. In May, foreign purchases of US securities were down 26 percent from April, the fourth consecutive monthly decline. Japan, holding 16 percent of US Treasuries, bought $20.1 billion of Treasuries in the months of April and May in contrast to average monthly purchases of $25 billion last year. We believe this outsourcing of the financing of the US economy is over, with perilous consequences for the dollar.

And now, the US dollar beset by global security concerns, spiking oil prices and the crushing weight of the twin deficits, has come under renewed selling pressure as the increase in the current account deficit and jobless numbers sent foreign investors scurrying into other major currencies and gold. The bulk of the selling came from hedge funds reversing their "carry trade". We believe the declining inflows will ripple across the globe.

The Implications Of Living In A China-centric World

The deteriorating trend in net US inflows suggests a growing reluctance by foreign private investors and central banks to shoulder this burden. Until now, Asian central banks were "the lenders of last resort". That has stopped. And, foolish politically inspired duties on China's furniture manufacturers is due to spark a reciprocal action. China has an increasing imbalance of trade and financial surpluses, piling up more than $400 billion in US Treasuries and has made moves to diversify into euros and more recently gold. In June, China purchased a net $700 million of treasuries, down from $3.1 billion the previous month.

China's voracious appetite for raw materials has caused huge price spikes raising concerns whether the price moves are sustainable. China has become a major player, with total trade expected to top $1,000 billion up from $851 billion last year, surpassing Japan as the third largest market. Indeed, the threat of a slowdown in China was enough to cause the global stock markets to selloff. As outlined in our last report, The China Syndrome, we believed the fears of a slowdown were greatly exaggerated. China is on the path for another 9% plus growth - it's not even a speed bump. China's imports are up a whopping 50 percent in the first half of this year due to a 40 percent increase in crude imports to 2.45 million b/d. Bank lending in June rose 16.3 percent. Industrial production rose 15.5 percent in July. While the world is focusing on China's growth prospects, investors appear to have missed the implications of this growth. China has accumulated large surpluses and a major part of US indebtedness, making it a world player in the financial markets.

Dollar Blocs, Euro Blocs, and Yuan Blocs

China's emergence as a superpower has not only helped Japan pull out of its ten year doldrums, it has been the driver for the emergence of the Far East as a super economy. And there is talk of a common Asian currency like the Euro to facilitate trade and investment. In essence, a common Asian currency would reduce currency risk and the dependence on US dollar, further undermining the greenback.

China's efforts to go from a state-owned and run enterprise to a more market economy has come at a cost. For example, its banking sector is in need of restructuring and there is still much to do about corporate governance. Nonetheless, the world is now discovering what it is like to live in a China-centric world. In 2003, China consumed 7 percent of the world's crude oil, 31 percent of its coal, 30 percent of its iron ore, almost 20 percent of its steel, 25 percent of its aluminum and 40 percent of its cement. No wonder foreign investment surged into China, making it the largest recipient of the funds in the world, exceeding the United States. China is now one of the world's twin economic engines, alongside the United States. While a new superpower has emerged, the old superpower, the United States is ageing.

For three years, a mixture of cyclical and structural factors has influenced the US dollar. A major part of the decline is due to the imbalance of Chinese production on the supply side and American consumption on the demand side. China is a powerhouse of exports, until their consumers take up the slack, the Chinese are dependent on America's insatiable appetite for goods. Here is the rub. Once the Chinese become confident in their own markets and the Asian countries begin to learn to rely on themselves and their markets , there won't be a need for America. Why then, will they need all those reserves of depreciating dollars?

The Golden Constant

After reaching a 16 year high, gold retrenched into a narrow trading range between $380-$410 an ounce, as the dollar recorded a "dead cat" bounce against other currencies. Gold is negatively correlated with the dollar. Is the party over? Not yet!

Investors are concerned that higher rates to prop the dollar will also hurt gold. A weak dollar goes hand in hand with higher rates. But higher rates and a weaker dollar also are inflationary. Three years after the business cycle peaked, the US economy is growing in fits and starts with an inflationary bias. Inflation has reared its head, due to the tremendous amount of liquidity injected into the system, in part to get the economy on track in time for the November elections. Until recently, inflation was low and falling. The oil price hit yet another peak at $46 a barrel reflecting a combination of strong demand, tight supplies and increased risk premiums. Commodities have turned around as tight inventories and strong demand have caused another spike in prices. Inflation is back.

In the past there was another parallel period, between today's deficits and the deficits of the seventies. In the seventies, the deficits surged with a war in Vietnam, an oil crisis and a surge in global inflation. The Fed Fund rate increased a net 14 times from 4.5 percent to 20 percent. Inflation soared to 20 percent and the dollar fell 70 percent. Gold moved from $35 an ounce to $850 per ounce. Today, the deficits are even larger and we have only begun gold's second leg. The dollar has fallen only 15 percent so $510 per ounce continues to be only an interim target.

Gold's bull markets are normally underpinned by a pickup in investment demand, then finds support from fabrication demand. Fabricators, build their holdings during corrections. Through the 1996 to 2001 bear market, fabricator demand picked up. When gold entered the bull market, fabricated demand actually declined because fabricators expected gold prices to pull back. But instead investment demand picked up due to heightened geo-political tensions, Chinese buying and large gold derivative inflows. Meanwhile industrial demand exceeded the western world's mine production. Central bank selling also slowed down and the new pact will limit central bank sales to 500 tonnes a year for another five years. De-hedging was also a big factor. Barrick, Placer and Cambior reduced their hedges in the latest quarter. Both Placer and Barrick have more than three years sold forward so they are expected to continue to deliver into their hedges. De-hedging has a positive impact on prices and producers are expected to continue to be among the biggest buyers of gold as they reverse their bloated hedge books.

Gold is unlike other commodities in that it cannot rust, deteriorate or spoil. Gold does not inflate like paper currencies. The supply of gold worldwide increased by about 2 percent per year, or about the same rate as the increase in the world's population. Compare that against the dramatic increase in the supply of US dollars. It is no wonder that gold as a discipline for central banks went out the window in 1971. In 1971, President Nixon severed the final link between the dollar and gold. The global monetary base grew by 55 percent between 1949 and 1969 - an average of 2.2 percent a year. Since 1969, the monetary base has grown four times by 1900 percent or 9.7 percent per year.

Gold does not pay interest. As such, misguided central bankers have been loaning or selling gold reserves in order to generate income. The gold bears have calculated gold's value over a hundred years versus treasury bill and found gold lacking since it pays no interest. However, those same analysts should look at the Seventies, when gold increased from $35 an ounce to $850 an ounce. Gold increased about 24 times or 2400 percent for an annual increase of 34 percent. To be sure there were no bonds during that period that returned 34 percent. Gold is indeed the ultimate hedge asset. Don't look now, but gold is rising. To repeat, $510 an ounce is only an interim target. Gold is a good thing to have.

John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040

August 23, 2004

The information contained herein has been obtained from sources which we believe reliable but we cannot guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.