THE G-7 EFFECT:
Selling into Dollar-Strength
Alex WallenweinThe financial press sees the 2005 London G-7 statement essentially as a non-event and reports "no change"in China's Yuan policy. All of this is widely seen as "dollar-supportive."
Nothing could be further from the truth.
A. Sealing the Dollar's Fall from Grace
Although there is some short to medium-term dollar support coming from the absence of a Chinese timetable on their revaluation efforts, the end-effect is only this: the rug is still being pulled from under the dollar's feet. The only difference is: the rest of the world's rear-end is being spared the dollar's hard landing.
Temporary dollar-strength is exactly what the rest of the world needs - particularly Asia and Europe. Temporary dollar-strength is exactly the opposite of what the US needs - despite all of Allan Greenspan's fluff about "market pressures, which appear poised to stabilize and over the longer run possibly to decrease the U.S. current account deficit." (Blah, blah, blah)
Vaguer words were never spoken. Yet, they predictably sufficed to reverse steep dollar-losses on Friday after the disappointing non-farm payroll figures were released. People are too lazy to look at the facts and think for themselves. We have all become "expert-junkies."
The reality is that continuing dollar-weakness now could be catastrophic for the entire world-financial structure. Asians and other countries desperately want to unload their tremendous dollar surpluses - but they can't, for fear that any larger-scale sell-off might cause a rush to the exit doors.
Therefore, what they all need is a temporary reprieve, a carefully engineered environment of apparent dollar strength that will allow them to quietly unload what they could never openly propose to sell:
Their dollar reserves.
Continued, incremental interest rate hikes by the Fed, although they showed next to zero effect until the beginning of this year, are providing the public rationalization for why the dollar is suddenly rebounding. This effect is bolstered by the ECB's decision to leave its rates where they are. The result is a climate wherein pressures on the euro decrease, Asians no longer need to convert so many of their dollar surpluses to buy US treasuries, the dollar temporarily "stabilizes" - and foreign countries can keep on selling their dollars into this artificial "strength" until they are home free, safely invested in euro deposits.
The final effect on the dollar is still as catastrophic, and still as inevitable as a sudden rush to the international exit-doors - but with far less deleterious consequences to the world financial system. For, once this artificial dollar-strength dissipates after all of the major players have decreased their holdings to below panic-levels, the currency traders of the world, those who bought into this strength to cover their previous dollar-shorts, will suddenly find themselves exposed to the icy winds of rapid-fire dollar-depreciation.
Whoever ends up selling euros or other currencies to these Asian CBs in return for their dollars will get stuck. The "good thing" (at least for the dollar-selling Cbs) is that they will no longer be exposed to a full-fledged dollar-flight when it finally occurs. But their "customers" (individual and institutional forex traders) will get stuck with the full weight of the dollar-bear as it collapses right on top of them.
B. The ECB and the Fed: Tortoise vs. Hare!
I theorized long ago in an early issue of "Moneypulation Watch" in mid 2003, that the ECB will let the US Fed pass it up in lowering rates, trail the Fed all the way down the interest-rate ladder, then stay at a point above the Fed's low and let the Fed turn around, pass the CB up again, and then slowly, slowly, ever so slowly, follow the Fed's incremental hikes back up - and that's exactly what they did and continue to do!
The Fed began its rate-tightening cycle in June last year. The ECB has stayed the course and remained at 2% for nearly two years now while the Fed went through considerable rate-gyrations. The ECB now has the luxury of keeping its rates low in order to slowly reawaken the rather flattened business cycle in Europe's big economies, while the Fed rates climb and climb. Naturally, the rising rates will serve to choke off economic activity at home as US consumers watch their buying power being drawn and quartered.
At the same time, the rising US rates take pressure off the euro, which gives EU exporters a much-needed breather. Without having to intervene in the currency markets, and without having to lower its rates even further, the ECB is turning into a master of the tortoise vs. hare strategy. On paper, the US economy has been dancing circles around the EU while the dollar was falling. Now, the dollar is picking up again and is starting to do likewise. While the turtle-like EU economy is slowly recovering and strengthening, the US hare's relative speed and agility is costing it much needed energy and resources. That will be its undoing.
When the Bush administration finally realizes that it has been "had," and that the apparent US strength advantage was simply a Judo trick designed to allow it to defeat itself, it will be too late. Once international CBs have safely unloaded their dollar-excesses into this current strength, the dollar-hare will be ripe for the grave that its feverishly active hind legs have already dug for it.
The ECB surely is a new breed of central bank. It obviously doesn't play this deadly game called "let's paper-over whatever difficulties that appear" - the game the US Fed has cherished for so long. Its more prudent strategy is now paying off. China's percentage of dollars accumulated as part of its $112 billion world wide trade surplus during 2004 stands at just above 25%, a significant decline from the year before. The difference went mainly into euro-denominated assets.
C. Chinese Currency-Whiplash?
China is undeniably on a path to diversification away from the dollar - and so are most other countries whose economies are of any consequence. For example in 2004, China's exports to the EU have increased by about 30% from those of 2003, as the EU's trade deficit with China has climbed from 32 billion euros in 2003 to 42 billion in 2004 - a direct result of China reducing its dependence on the already over-extended US export market.
In Davos on January 26, 2005, the director of the National Economic Research Institute at the China Reform Foundation named Fan Gang (not a part of the official policy-making circles) remarked that China was looking to move its currency peg away from a pure dollar peg to a basket of currencies, including the euro. This remark was later disavowed by actual Chinese policy honchos. As a result, the dollar recovered from its initial slump in reaction to that piece of news.
What has apparently escaped forex traders is that this policy was actually confirmed and re-confirmed by several Chinese officials in policy-making circles. In fact, a Reuters piece of February 3, 2005, stated that an unnamed G7 source "confirmed comments made by Italian Economy Minister Domenico Siniscalco on Wednesday that at previous summits the Group had discussed with China the idea of pegging the yuan to a basket of world currencies rather than the dollar."
This is the early stage of the realization of a prediction I made back in late 2003, in an essay entitled Gold, the Yuan, the Dollar, and Taxes. In that essay, I doubted that the Chinese would lift their dollar peg anytime soon, but will likely shift it to a euro-peg so its export-advantage can be shifted from the US to Europe - once the US consumer appears to have reached his purchasing limits. That is now happening.
Bottom line: The dollar's current move "up" the forex ladder only makes its eventual decline and exit-left from the world's reserve-currency stage an even greater certainty.
D. The Effect on Gold
Since the gold price is currently still tied to the dollar's movements up and down that ladder, expect gold to continue to decline and then stagnate for a while. But when cu8rrency traders begin to realize the trick being played on them for what it is, the ongoing fall will resume all the more ferociously. Even if a "ferocious" can be avoided (unlikely but possible), the worst factor weighing in against the dollar's long term prospects is the inevitable persistence of the fall.
The dollar will go lower, ergo gold will go higher. It's as simple as that.
Eventually, of course, gold will leave its dollar-dependence behind as international investors and institutions, lead by the Chinese, will use both physical supplies and trading instruments to hedge against growing fiat-currency risks. Gold investors should follow the international CBs' examples, take advantage of current fire-sale prices, and keep selling dollars into this contrived strength, except that they should sell dollars for physical gold - not for euros (or other fiat basket-cases).
February 6, 2005
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