Dollar Dilemma
Euro Supply versus Dollar Supply
The Euro-Area's M3 growth rate rose to 5% in March from 4.7% in February. As reported on Bloomberg, this is above the ECB's target of 4.5% and thus makes a rate cut unlikely in the near future.
The Fed, however, does not have any targets for money supply. In fact, Alan Greenspan testified last year that he and his Fed cohorts not only didn't pay much attention to the monetary aggregates when framing monetary policy, they also had difficulty defining what actually constituted money these days.
With US M3 having grown at a 13% rate since the beginning of this year it is just as well the Fed governors do not take the monetary aggregates into account. Doing so would severely constrain their ability to slash official interest rates.
So, we have the ECB deciding not to cut rates, partly because money supply growth has ramped up to 5%, whereas the Fed has been aggressively cutting rates despite a double-digit money supply growth rate. The strange thing is, the euro-dollar exchange rate has thus far been mostly unaffected by the growing scarcity of euros relative to dollars. It seems as if the international demand for US Dollars increases to match every surge in Dollar supply, but we think this aberration will soon be corrected.
The US financial sector and the Fed cannot afford to let the money supply growth rate wane lest the pillar that is keeping the US economy from collapsing - the robust housing market - begins to crack. If the ECB sticks to its guns and prevents the supply of euros from increasing at a more than 4.5% rate, we should soon reach the point when changes in the relative quantities of the two currencies cause a substantial upward adjustment in the euro-dollar exchange rate.
Dollar Decline on the Horizon
The Dollar is going to run into some serious trouble as investors throughout the world adjust to a new paradigm - a world in which inflation is not only on the rise, but a world in which inflation is boosting the prices of the things that are included in the popular inflation statistics such as the CPI. The adjustment process has been proceeding for several months, as evidenced by the good performance of resource-oriented stocks and the recent poor performance of bonds, but the vast majority of market participants still need to come to terms with the fact that deflation is not the issue - inflation is.
The Dollar is now particularly vulnerable because, based on their modus operandi of reacting to backward-looking economic data such as last week's worse-than-expected Employment Report, the US monetary authorities are sure to continue pushing short-term interest rates lower at the same time as the symptoms of inflation are becoming more and more obvious. The Dollar's value relative to the major European currencies is therefore going to be hit from three directions. First, US inflation statistics will be worse than European inflation statistics. Second, for the next several months US economic growth is going to be worse than, or at least no better than, European economic growth ('Dollar bulls' will no longer be able to play the 'growth card'). Third, the ECB's focus on inflation and the Fed's focus on growth will mean that a) the interest rate differential between the euro and the Dollar will swing further in favour of the euro, and b) the supply of Dollars will continue to grow at a faster pace than the supply of euros.
The May-15 FOMC Meeting may be the catalyst that begins the Dollar's slide, especially if the Fed cuts rates by 50 basis points in parallel with a surprisingly-high CPI (the April CPI is reported on the same day as the FOMC Meeting).
Current Market Situation
With the Dollar Index being affected by 'hot money' rotating between Europe and Japan it has seemed, over the past several weeks, as though the euro and the Yen were sitting at opposite ends of a seesaw with the Dollar sitting in the middle. We have therefore decided to focus our attention on the Swiss Franc (the currency with the strongest positive correlation to the gold price). A weekly close above 0.5950 would break the SF's 4-month downtrend and suggest that its next upward leg has commenced. The traders' commitments for the SF are extremely bullish, with 21142 speculative 'shorts' versus only 457 speculative 'longs', so there is certainly plenty of 'short-covering fuel' available to propel the SF's next rally.
The XAU has thus far failed to break through resistance in the 55-57 area. Consecutive daily closes above 58, something we expect to happen by the end of May, would suggest that a substantial rally was underway. The daily XAU chart indicates some short-term downside risk within the confines of an overall up-trend, but we think the greatest risk at this time is in NOT being invested in the gold sector.
As discussed above, the Dollar looks very vulnerable at present. We expect the Dollar to begin a multi-month decline during the second half of this month, thus propelling gold and gold stock prices much higher.
Steve Saville
Hong Kong
9 May 2001
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