The Dollar

Every time the Dollar falls versus the euro it is due to concerns over the slowing US economy and every time the euro drops against the Dollar it is due to concerns over the slowing European economy. At least, these are the explanations typically given to explain movements in the foreign exchange rates. Apparently, there has been a sudden realisation over the past month that the US economy is slowing and that is why the Dollar has been relentlessly sliding lower.

Our take on what has been driving the euro-Dollar exchange rate is quite different and is summed-up by the following extracts from our July-11 commentary:

"...the strength of the US$ so far this year has nothing to do with economic fundamentals and very little to do with the popular idea that the US$ is benefiting due to a lack of viable alternatives. The US$ has risen on the back of speculative money flows seeking to profit from a) an interest rate spread, b) the seemingly-limitless liquidity provided by the US financial system (underwritten by a central bank that is prepared to tolerate a double-digit money supply growth rate), and c) a rising trend in the Dollar's foreign exchange value. The trend in the Dollar's foreign exchange value is a 'chicken and the egg' situation in that a rising trend attracts additional foreign investment which, in turn, contributes to the rising trend."

And: "Once the Dollar's upward trend is perceived to have changed, the alarm bell will sound and many of the leveraged positions purchased by foreigners will need to be exited in a hurry to protect profits or limit losses. Remember - we are not talking about long-term investments, we are talking about short-term speculations that do not make any sense unless the Dollar's short-term trend remains up."

The Dollar's short-term trend is now DOWN, so we are probably getting close to the point where the liquidation of foreign-owned US securities will begin in earnest.

As the following chart shows, the Dollar Index is now sitting right at its 200-day moving-average. This means that foreigners who purchased US$ assets or debt over the past 200 days are, on average, now at the break-even point in terms of exchange-rate changes. The 200-DMA has held thus far and there is good support in the 114-115 range, but once below 114 a quick drop to the January low at around 108 is likely.

Whilst the Dollar was climbing higher during the first half of the year the 50-day moving-average acted as strong support and every excursion into 'oversold' territory (as determined by stochastic momentum indicators) led to an immediate upward reversal (points B to F on the above chart). Also, as it moved higher the Dollar remained 'overbought' for extended periods in March, May and June. However, the 'character' of the market is now very different. The Dollar became 'oversold' during the third week of July (point G on the chart) and has, as at the time of writing, remained oversold for 4 weeks.

We think the Dollar is now in a bear market that will extend, at a minimum, through to the end of this year.

Gold Sentiment and Investment Demand

There is a very negative article on gold and gold shares in the current edition of Barrons. The flavour of the article is obvious from its title: "Fool's Gold? Even longtime supporters are skeptical about the gains in mining shares". Its conclusions are that a) there is no logical reason for the out-performance of gold shares over the past 12 months, and b) gold and gold shares are likely to go nowhere in the foreseeable future.

Those who are long the gold sector should lick their lips when they read an article in the mainstream press such as the latest Barrons piece because it is an indication that gold stocks are still much closer to the bottom than to the top.

Many members of the mainstream financial press seem to have caught-on to the idea that gold stocks have been performing relatively well due to expectations of a weaker Dollar, but they often make the mistake of assuming that a weaker Dollar is positive for gold because it makes gold cheaper in terms of other currencies. It is, however, a rising price, not a falling price, that stimulates investment demand (for any investment, not just gold). In a gold bull market the gold price increases in terms of all currencies, not just the US$. The number of people who want to own gold increases as the gold price rises in terms of their local currency.

The US$ gold price has great significance because the US$ is the linchpin of the world's fiat money system and is gold's major competitor. As long as the US$ remains strong compared to the other fiat currencies and maintains its international purchasing power, there is little incentive for the majority of investors to buy gold. A persistently-weak Dollar, which we currently do not have but probably will have in the future, indicates a general loss of confidence in the entire fiat money system and prompts people to seek a monetary store of value outside the realm of government-mandated currency.

Below is a chart showing the price of gold in terms of the euro since the beginning of this year (the chart source is the Pacific Exchange Rate Service). When the gold price spiked up at the end of last week in response to a drop in the US$ we read that gold was being bought by people outside the US supposedly because the weaker Dollar was making it cheaper. However, the chart clearly shows that the euro gold price was cheaper throughout the first 4 months of this year than it is now (note that this applies to all the world's currencies, not just the euro).

As the US$ loses its appeal we should see the gold price rise in terms of all the world's currencies, not just the US$, in response to a general loss of confidence in fiat money. And as the gold price rises the investment demand for gold will increase. Very few people in the world purchase an investment because it is getting cheaper. Most people extrapolate the present into the future and therefore like to purchase an investment after it has become more expensive.

Steve Saville
Hong Kong

14 August 2001

The reader is invited to respond to Mr. Saville's wisdom via email:
sas888@netvigator.com

Regular financial market forecasts and analyses are provided at our web site:
http://www.speculative-investor.com/new/index.html
One-month free trial available.