As a Canadian, the phrase "dollar woes" has, over the past decade, referred to the Canadian Dollar. And it has been justified. In November 1991 the Canadian Dollar hit a high of 0.8906 (nearest futures) against the US Dollar. But by January 2002 a long slide had taken it down to 0.6170 a drop of over 30%. Headlines abounded that the Canadian Dollar was soon destined to fall to 0.50 and even lower. While some politicians railed about the weakness of the dollar and the incompetence of the government business was largely silent. If you were an exporter you had nothing to complain about as the Canadian economy grew and prospered led by exports that were favoured largely because of the cheap Canadian Dollar.
Back in 1974 the Canadian Dollar was even stronger hitting a high over 1.04. But the election of an avowed Quebec separatist government in 1976 sent the dollar on a long tumble to 0.69 by 1986. A high interest rate policy in the late 1980’s helped bring capital flows back to Canada and a rise to the 0.89 level was underway.
Despite the woeful performance of the Canadian Dollar in the 1990’s studies under a theory known as Purchasing Power Parity said the proper value of the Canadian Dollar was around 0.80. If that is the pivot point, we then know that the longer term value of the Canadian Dollar will probably revolve around that level but there will be periods of under valuation followed by periods of overvaluation. The current rise to 0.72 plus tells us that the period of under valuation is probably over but that we are not yet back to fair value and a period of overvaluation. That period is to come.
But while the long period of a weak Canadian Dollar was beneficial to Canadian exporters, Canadians whose earnings were in US Dollars and Canada as a whole, a rising Dollar is problematic for the opposite reasons. Many businesses that were efficient and competitive at the lower valuations may prove to be quite uncompetitive at higher valuations. As well there is some concern that a higher dollar will cause inflation, as Canada’s primary exports are commodities that will now rise in price. With Canada’s primary exports going south to the United States the higher Canadian Dollar could prove to be "dollar woes" of different sort.
But south of the border there is potential "dollar woes" of a different sort. On the surface a lower US Dollar that has been overvalued now for years should be good. While some confusion is emanating from Washington on where they would like the dollar, Treasury Secretary Snow has indicated (in couched language) he would prefer a weaker dollar. This would be a departure from the stated strong dollar policy that had prevailed during the Clinton years under Treasury Secretary Rubin. For Alan Greenspan who has worked with both Rubin and Snow he appears to be supporting Snow with a low interest rate policy.
But while a lower dollar could prove to be positive for US exports and for those whose earnings are predominately in other currencies it brings a different set of problems. The US recently reported the second largest trade deficit ever for March 2003 at $43.5 billion. Despite the weaker US Dollar the deficit actually widened as imports grew, primarily higher costing oil and gas that rises in price as the US Dollar weakens. Exports grew but the value of imports grew faster. While higher priced commodities could still prove problematic for US imports going forward a rise in exports is not a given as weak economic growth in Europe and Japan, two of the US’s main trade partners, could curb demand for the foreseeable future.
A lower dollar while potentially positive for exports could be extremely problematic, however, for financing the huge US twin deficits of trade (estimate of up to $500 billion/year) and budgetary (estimate of up to $300 billion per year) and in a more general sense the upwards of $30 trillion of US debt. The US needs to import capital to finance these deficits and with the low interest policy this could prove difficult as foreign investors are losing twice with low interest rates and a falling dollar.
And on the other side others who are heavily export dependent such as Japan could enter into "beggar thy neighbour" policies and look to devalue their own currencies in order to protect their competitive export position. The US has attacked trade barriers in other countries while at the same time erecting barriers in the US (steel, softwood lumber, wheat etc. not to say that those that did not support them in the war against Iraq would face consequences). These are classic "beggar thy neighbour" policies, which were at the heart of the 1930’s Great Depression. Already there has been "tit for tat" trade retaliations particularly between the European Union and the US.
But what should be important to investors is the possible impact on their investments, stocks, bonds and gold stocks. For gold bugs we all wish that a falling US dollar were a repeat of the 1970’s. It was at the beginning of the 1970’s that President Richard Nixon took the world off the gold standard, set currencies free to float against one another and set in motion the ability for the Federal Reserve and the banking system to expand both money supply and loans exponentially.
The brave new world of floating currencies set in motion a fall in the US Dollar and the great gold boom. Both peaked (bottomed) in early 1980 as gold soared to over $800/ounce. Stock markets roiled through the 1970’s as the Dow Jones Industrials vacillated between a low of 570 (1974) and highs just over 1000. The final low of course for the stock market was not until August 1982 although by that time the US$ was in a new period of ascendancy. Bonds during this period rose sharply in yield (prices falling) peaking at over 20% in the early 1980’s. The bond market made its final high yields in 1981.
Of course the period of the 1970’s has been noted as the Kondratieff summer where commodity prices rise (including gold) while interest rates rise and stock markets swoon. The US$ and gold bottomed first in 1980 followed by the peak in bond prices (1981) and the bottom in stocks (1982). The 1980’s brought us the Kondratieff autumn where the characteristics are falling commodity prices, falling interest rates and rising stock prices culminating in a bubble.
Here the record with the US$ is more mixed. The US$ rose from 1980-1985. Gold during this period was definitely on the downside bottoming in 1985 with a sharp interim countertrend rally in 1982-1983. Stocks did rally during this period especially in 1983. And bond yields fell although it was not until 1984-85 that bond yields really began to fall. The dollar topped in February 1985 (and gold bottomed) and in September 1985 the Paris Accords started a sharp drop once again for the US Dollar. But bond yields continued to fall (prices up) topping in April 1986, although bond yields remained low until the final low in March 1987.
The stock market took off topping August 1987 followed by the stock market crash in October. Gold rose steadily during the period as the US$ fell. Gold topped in December 1987 coincident with the bottoming of the US Dollar.
The record since 1987 has been somewhat more uneven but generally gold and the US$ have inversely followed each other. Our monthly charts of the Swiss Franc (representing the US$), Gold futures, Stocks (represented by the Dow Jones Industrials) and US Treasury bond futures shows the ebbs and flows. We have labeled the charts for the up and down periods as well we have noted important highs and lows. Both gold and the US Dollar continued to generally be the inverse of each other. We note important highs in gold in January 1991 (a secondary high) and a bottom in the US$ in February 1991 then important highs in the US$ in March 1993 and low in gold in February 1993. The US$ then made its final low in October 1995 while gold hung on until February 1996. From 1995 to 2000 the US$ was strong. Gold was in a long downdraft while both US bonds and the stock market rallied. We note that the US$ made its final high in June 2001 while gold bottomed in May 2001. Since then both have once again been inverse to each other.
While generally stocks and bonds followed the pattern of strong dollar, bonds (prices) and stocks up and weak dollar, bond (prices) and stocks down there were some significant leads and lags. This may have occurred because the Federal Reserve followed deliberate low interest rate policies. This coupled with the strong dollar meant that stocks soared. Significant easing in credit conditions also contributed ultimately as well to the strong (bubble) stock market. Throughout this there remains one very significant difference.
This occurred in 1998 at the time of the Asian/Russian crisis that culminated in a sharp shakeout in the stock market. Bonds, however, rallied strongly as the Fed cut interest rates aggressively. As stocks bottomed, interest rates also bottomed and a sharp price sell off was seen in bonds. In January 2000 as the stock market was topping, bonds bottomed. Since then with the easy monetary policies of the Federal Reserve bonds have been rallying while stocks have been falling. The one out of step is bonds as this has generally coincided with the US$ beginning its fall and gold rising.
The characteristics of the Kondratieff winter is, however, one of falling stock prices, rising gold and generally interest rates remaining low. So if, as many believe, the Kondratieff winter started with the stock market top in January/March 2000 then the pattern thus far fits. But it is a divergence from what has generally been experienced over the past thirty years. What would send interest rates soaring is a serious credit crunch, an event that has not as yet happened in this cycle yet.
Although the US$ has weakened considerably since topping two years ago we have not as yet experienced a full dollar crisis. The current rift in the world over Iraq accompanied with the threat of trade retaliations is not a policy that will result in strengthening the US$. With record trade and budgetary deficits the US can ill afford to jeopardize capital flows that are required to finance these debts. The current strength in the stock market appears to be largely the result of the ongoing easy monetary policy being followed by the Federal Reserve. A serious assault on the US$ especially if there is a realization that the US will not defend the dollar could trigger that crisis. An attempt to leapfrog through competitive devaluations by other countries concerned about protecting their export competitive position could trigger an serious currency crisis.
It is one thing to have a currency crisis as we last saw in 1998 largely with secondary currencies. It is another thing to have a crisis with the world’s reserve currency. Investors would be well advised to be aware of this relation between the US Dollar, gold, stocks and bonds. A US Dollar crisis would trigger a stock and bond crisis and a rush into gold. The historical reference tells us that has been the way it has been for years particularly since the world abandoned the gold standard some thirty plus years ago.
David Chapman is a director of the Millennium BullionFund
www.bullionfund.com.
