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Interest Rates and US Dollar

April 20, 2005

For successful investment decisions it is necessary to recognise the main driver for a future development and then adjust accordingly the investment strategy.

One of the most important factors in investment is the US dollar and its strength versus other currencies. As the consequences of a weak or strong dollar are very well understood in the financial world, it is by far not clear what is the main reason for US dollar movements.

The US budget and trade deficit are certainly not a main factor on the US dollar - as suggested by the financial press worldwide. Just in the moment when the US announced a record US trade deficit, the US dollar substantially increased. This is the opposite what should have happened according to the economic textbook.

But what is it then what influences the US dollar the most ? Interest rates are very likely one of the most influence factors as the interest rate rewards the holder of a currency.

Nevertheless, when the development of the US dollar is compared with short and long US interest rates, there is no clear correlation between US dollar and nominal interest rates. US interest rates declined on average over the last decades, the US dollar instead rose over 15 years - despite a huge trade deficit. Only during the last four years the US dollar weakened (see below chart)

Interestingly the above chart shows how sensibly the bond market predicted the FED actions on the up and downs of interest decisions. The bond market could very well assess the future development of the US economy. Currently the market predicts that the interest cycle has come to its end and lower interest will prevail soon.

The picture changes substantially when the US dollar is compared with real short and long term interest rates. Up to 2001 US real short and long term interest rates have been positive. Long term real rates have been consistently between 3 and 4 % despite falling nominal rates. This is exactly what has kept the US dollar strong. In assessing the US dollar it is important to understand the psychology of an US dollar investor. What concerns him is the real return on its investment. Consider it just like a share in a company which pays dividend. The real rate is the dividend on the US dollar. So, if the dividend is ok, it does not matter how big the US budget or trade deficit is. In that sense the demand for US dollar is virtually limitless. If the real return on the US dollar is high versus other currencies then worldwide money savers will always prefer the US dollar, despite much higher nominal interest rates for some currencies (Venezuela, Russia, Brazil,… yield more than 10 % , yet the real rates - adjusted for inflation - have been much smaller than for the US dollar over the latest years).

In order to demonstrate this mechanism just a few examples: Euro bond yields have been around 3,5 % over the last few years yet inflation stand around 1,5% (versus 3 % in the US ) This gives a real return of 2 %, which is more than in the US, thus the recent strength of the Euro versus the US dollar. Japanese bond yield have been around 2 % over the last decade, yet adjusted for inflation, which has been virtually zero in Japan, the real bond yield stands at once again 2 % and keeps the Japanese Yen in equilibrium with other currencies.

It is when the real rate on a currency falls, the currency weakens, just like it is now the case in the last few years in the US dollar. On the other side, if the real rate on the US dollar goes up - as it has been in the last few weeks - the US dollar strengthens temporary despite record trade and budget deficit (see above chart).

During the past three years it has been difficult for the US economy to earn a real rate more than 2 % as this has been the case in the nineties. The internal strength of the US economy is not high enough to deliver higher real interest rates. In the nineties the US could generate highly innovative products such as the PC and the internet, which gave the economy high strength. Nevertheless, these products are now in a very mature phase and do not yield any more a high return for the US economy. The US simply lacks of high yielding innovative projects, products and companies to pay a higher yield than 2 %on its currency. Furthermore the US economy could already feel the burden of high debt service, which also can lower the overall efficiency of an economy.

The current situation is perfectly depicted in the below picture. Despite the efforts of the US FED to increase the real return on the US dollar through increasing the FED Funds, the US economy cannot deliver on these higher real rates and starts to weaken.

It is only a question of time now, when the US FED has to lower again the FED Funds due to extreme weakness of the US economy, especially in the previous stalwarts of the high tech industry. The US economy simply cannot afford to pay a higher real rate on its currency. This will lower the real rate and further weaken the US dollar.

The consequences of a weak US dollar are now well know as shown in the below picture.

In this context it is also very important to understand that a weak US economy - which translates in to a weak US dollar - is very stimulative for the world economy. The World economy needs the US dollar carry trade i.e. borrowing at low rates in US dollars and investing at higher return in the rest of the world. The weaker the US economy, the stronger the rest of the world.

So, if we get a recession or even a depression in the US and in Europe, this will be certainly good news for commodities, gold and silver as then the carry trade propels the World economy to new highs. Think of it as an inverse Asian crisis. At the end of the nineties, the strong US - and also the European economy attracted a lot of capital into the US and Europe, which actually weakened the rest of the world. This time around it is just the opposite - the weak US and European economies lead to an extremely strong capital flow into Asian, Russian, Latin American and even African economies thus strengthening the demand for worldwide commodities.

If the US economy would be isolated from the rest of the world then certainly a weaker economy would drag down commodities. As the US economy today is not more than an ever shrinking share of the world economy, a weaker US economy - and therefore a weaker US dollar - means just extremely favourable liquidity conditions for the rest of the world.

This has been certainly not the case during the great depression in 1930 when the US and European economies represented nearly 80 % of worldwide economic activity. Today this share stands already below 35 % and a weak US and Europe will do not any more harm to the world-wide economy. So, today we have a complete different situation than in 1930 and a weak US and European economy would just provide extremely favourable financing conditions to the rest of the world and gold, silver and all other commodities will thrive under this scenario.

So what should an investor do now ? As recent data on housing and manufacturing suggest that the US economy can hardly bear the recent interest hikes by the US FED, interest rates, inflation and the US dollar are to fall quickly in the next months. Possibly inflation will slow down close to zero by year end for most industrialized economies.

This is certainly good news for investors in the commodity sector as the FED Funds and bonds will be far below 3 % during the course of the current year. Gold and silver and commodities will reach record highs. It is now in my view the time to step up investments in the commodity sector as a breakout seems quite near, especially when it becomes clear that inflation in the US and Europe will fall substantially and Central Banks have no other choice than to lower interest rates.

I look forward to receiving your comments

Heinrich Leopold

[email protected]

April 20, 2005

Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.

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