As usual, the market is over-thinking and over-analyzing the US Federal Reserve Open Market Committee Statement released Wednesday where the Fed conveyed its decision to keep the overnight interest rate steady at 5.25%. It appeared that the Fed’s hawkish tone towards inflation was easing and even though the Fed expects the economy to continue to expand at a moderate pace over coming quarters, one has to wonder how much of the change in the Fed’s tone is due to the current problems in the real estate sector.
While the dollar exchange rate showed little reaction to the Fed’s statement, the equity markets in the US rallied, as did gold. That both gold and equities had the same response is to be expected: if the Fed is less likely than before to raise interest rates it may be more inclined to lower interest rates in the event economic activity takes a bigger hit from the real estate sector. Lower interest rates are good for stocks, lowering the borrowing costs of corporations and making bonds (which compete with stocks for capital) less attractive. Lower interest rates are also positive for the gold price since lower interest rates would most likely cause the dollar exchange rate to weaken, thereby increasing the gold price in US dollars.
But by Friday the market had changed its mind. According to interviews by Wall Street Journal journalists the market now thinks that Wednesday’s Statement was not a move towards a dovish stance, but merely a move towards neutrality. In response to the change in sentiment the dollar rallied and the gold price fell.
As I said, I think people over-analyze these things. Short term fluctuations in the market are due to fickle emotional reactions by investors to new information, and are impossible to predict with any kind of consistency. On the other hand, longer term events that are based on fundamental changes or inconsistencies are far easier to predict even though the timing of such events is equally impossible to predict. Along those lines, a comment by the People’s Bank of China’s Governor, Zhou Xiaochuan, regarding that country’s more than one trillion dollars’ worth of foreign reserves, is far more important than what the Fed said this week.
Zhou was quoted as saying: “... many people say that foreign exchange reserves in China are large enough. We do not intend to go further and accumulate reserves.”
China’s vast and rapidly growing foreign exchange reserves accumulate because China does not sell the surplus US dollars that it receives from its trade surplus with the United States into foreign exchange markets, but buys US debt with them instead. Under normal circumstances China would have sold its surplus US dollars and not accumulated such a vast foreign exchange reserve; however, the United States’ trade deficit is so large that if China, Japan and Europe were to sell their trade dollars into foreign exchange markets the dollar exchange rate would collapse.
Last year the Organization for Economic Co-operation and Development (OECD) determined that the dollar had to fall by 35% to 50% in order to balance the US current account gap. My calculations of the dollar’s over-valuation based on the gold price also suggest that the dollar has to fall by about 35%.
China does not have to sell any of its existing dollar reserves to precipitate a decline in the dollar -- all it has to do is stop accumulating dollars. The current US trade deficit with that country alone is running over $20 billion per month, and that is not an insignificant amount. If China stopped accumulating foreign reserves those dollars would be sold and I expect that when that happens, the dollar will fall.
Other Asian countries that helped prop up the dollar by accumulating foreign reserves may follow China and start selling their surplus trade dollars as well.
The ramifications are that there will subsequently be less demand for US Treasuries and agency debt. That will push US interest rates higher regardless of what the Fed says, and higher interest rates will be detrimental to US economic growth and US equities. One would expect that higher US interest rates would be positive for the dollar, but with surplus trade dollars hitting foreign exchange markets we can expect to see the dollar fall in tandem with rising interest rates. A falling US dollar in the face of rising US interest rates is the key event that I am waiting for to indicate that a significant and sustainable rise in the gold price is occurring. Until then the gold price should continue to creep upwards as a result of fiat money inflation.
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Please note that there will not be a commentary next week: I will be away on a property visit.
This letter/article is not intended to meet your specific individual investment needs and it is not tailored to your personal financial situation. Nothing contained herein constitutes, is intended, or deemed to be -- either implied or otherwise -- investment advice. This letter/article reflects the personal views and opinions of Paul van Eeden and that is all it purports to be. While the information herein is believed to be accurate and reliable it is not guaranteed or implied to be so. The information herein may not be complete or correct; it is provided in good faith but without any legal responsibility or obligation to provide future updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility, or assumes any liability, whatsoever, for any direct, indirect or consequential loss arising from the use of the information in this letter/article. The information contained herein is subject to change without notice, may become outdated and will not be updated. Paul van Eeden, entities that he controls, family, friends, employees, associates, and others may have positions in securities mentioned, or discussed, in this letter/article. While every attempt is made to avoid conflicts of interest, such conflicts do arise from time to time. Whenever a conflict of interest arises, every attempt is made to resolve such conflict in the best possible interest of all parties, but you should not assume that your interest would be placed ahead of anyone else’s interest in the event of a conflict of interest. No part of this letter/article may be reproduced, copied, emailed, faxed, or distributed (in any form) without the express written permission of Paul van Eeden. Everything contained herein is subject to international copyright protection.
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Paul van Eeden is an independent investor, analyst and newsletter editor.
Born in South Africa, Paul graduated from university with a degree in chemistry and applied chemistry with additional credits in accounting, economics, business economics, philosophy, statistics, mathematics, biochemistry and physics.
Paul's first business was an African art distributorship, of which he acquired a 50% interest during his first year at university in 1985. He has experience, either as an owner, manager or director, in plastics manufacturing, food supplements and cosmetics distribution, advertising & marketing as well as the manufacturing and distribution of gas detection equipment.
Paul van Eeden left South Africa in 1994. He joined Yorkton Securities in Toronto as a stock broker in 1995 and moved to Global Resource Investments in Carlsbad, California in 1996. In November 2002, Paul decided to leave the brokerage industry and joined Doug Casey as co-editor of the International Speculator (www.internationalspeculator.com) newsletter.
His investment approach was shaped by the ideas of Benjamin Graham and David Dodd so Paul is always on the search for tangible value that can be bought at a reasonable price. That can usually be accomplished only during the trough of a market, which is currently not the case for general US equities.
Therefore Paul decided to focus on the natural resources sector, specifically gold. The period from 1996 to 2001 was a trying time - the bottom of the worst bear market in gold in twenty years - but, of course, it was also a time of opportunity.
At the San Francisco Gold Show in November 1998, Paul van Eeden introduced his original thesis that the gold price in US dollars is driven by the US dollar exchange rate, and that traditional commodity style analyses would not yield predictive results when applied to gold. He showed that a dollar-only view of the gold market is inadequate: understanding the gold price requires a global view, incorporating exchange rates across many currencies. This novel line of thinking is now ubiquitously accepted.
In 2003 Paul went further, showing that the price of gold in US dollars is tightly correlated to the expansion of US monetary aggregates (M3) and that an analysis of gold as money not only clarifies the gold price from 1971 to the present, it has other implications that are still unforeseen by most financial and commodity analysts today. One of these is that the gold price will soon exceed $1,000 an ounce. Another is that, aside from operational differences, not all gold mining companies will benefit equally from this increase in the gold price.
Paul van Eeden not only does his own research on the fundamental drivers behind the gold market, he also takes a hands-on approach to investment analysis: interviewing management, studying exploration projects and visiting mining operations. Whilst investing in mining and exploration companies is inherently risky, value is never far from his mind and features forcefully in his selection criteria.
Most of Paul's time, now, is devoted to finding investments for his own portfolio.
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