Gold and the
Dollar, Post Disaster
Overview
It is impossible to put aside the traumatic
events of last week, but our responsibility is to provide objective analysis
of the financial markets and that is what we will try to do. In today's
commentary we are going to step back and update our views on the currency
and gold markets.
In summary, we don't think that last
week's senseless devastation will change the direction of the markets beyond
the very short-term. We do, however, expect that trends that were already
in place will be accelerated and new trends that were set to begin in the
near future will be magnified. For example, the Dollar was already trending
lower and gold was trending higher prior to 'the event'. Regardless of
what happens over the next 1-2 weeks as governments and central banks intervene
in the markets in one form or another in an attempt to create the illusion
of stability, the eventual drop in the Dollar and the rise in the gold
price are now expected to be greater than would have otherwise occurred.
Also, it is probable that the coming stock market rally will now be of
greater magnitude and duration than we had previously expected.
As an aside, when the US stock market
re-opens on Monday our belief is that each investor/trader should do what
they think is right based purely on financial considerations. This is what
the 'big money players' will be doing. Some commentators have implored
retail investors to be patriotic and not to sell on the basis that panic
selling would hand the terrorists another victory. However, being patriotic
and being bearish on the stock market (and acting on that view) are two
totally unrelated things, even in the wake of such a disaster. If the selling
or short-selling of US stocks is now unpatriotic, then so is the buying
of gold or any other actions taken by Americans to protect themselves from
the likely depreciation of their over-valued, government-manipulated, debt-based
dollars. We don't think it makes sense to sell into any panic that
might occur over the next few days (actually, we don't think a major panic
will occur), but the decisions of each individual investor/trader should
be based on financial considerations only. If the right thing to
do is to sell, then calls for the retail investor to sit tight will just
help the 'big money players' distribute their stock at a higher price.
The Dollar
We expect to see a rebound in the Dollar
if, as anticipated, the US stock market does not plunge after trading re-starts
on Monday. However, we think that any strength in the Dollar will be fleeting
(lasting anything from a few days to 2 weeks). Here's why.
One of the US economy's major weaknesses
has been the reliance on investment capital in-flows to offset current
account out-flows. In order for the foreign exchange value of the Dollar
to hold its ground it was necessary that the US not only attract foreign
investment, but attract it at the rate of more than $1B per day. However,
the recent disaster is going to increase the perceived risk of investing
in the US at a time when the potential rewards will be seen to have diminished.
For example, both economic growth and short-term interest rates will be
lower for at least the next 2 quarters than would otherwise have been the
case. (Take no notice of any statements to the effect that this disaster
will somehow provide a boost to economic growth. Re-building something
that has been demolished cannot possibly cause real economic growth.)
Going into last week we were expecting
some near-term firmness, or at least stability, in the Dollar prior to
a resumption of its decline. Tuesday's events clearly altered the pattern
and we now expect a Dollar rebound over the coming week or so. As mentioned
above, any strength will most likely be short-lived as the events of last
week will have the effect of accentuating the downtrend that was already
in force.
Gold and Gold Stocks
Below is a long-term chart of the gold
price. The chart data has not been updated since Sep-10 and the chart therefore
does not show the upside breakout above the 5-year downtrend that occurred
last week.
We were expecting a gold price rally
to begin during the second half of this month and that a break of the downtrend
would lead to a quick-fire move to resistance in the 315-325 range. However,
as is the case with the Dollar the events of last week have changed the
expected pattern. If the Dollar strengthens over the coming week as we
expect then the gold price is likely to consolidate its recent gains, but
any counter-trend reaction will probably be short-lived. We strongly believe
that the events of last week will increase the investment demand for gold.
The consensus view seems to be that
the gold price will quickly fall back to its pre-crisis levels and stay
there. This view ignores the fact that gold-related investments have been
trending higher since November of last year and that, prior to the events
of last week, the evidence pointed towards a continuation of that trend.
Even if we assume that there will be no additional crisis-related buying
of gold, it is almost assured that the yield spread will continue to widen
and real (inflation-adjusted) short-term interest rates will continue to
fall as the Fed pushes rates lower and forces liquidity into the system.
It is difficult to imagine a more bullish environment for gold and gold
stocks. As such, any near-term weakness in the prices of gold and gold
stocks should be used to add to positions.
Amongst other things, gold is a hedge
against the loss of confidence that occurs as a result of inflation. Prior
to last week's events we had assessed the probability of the US experiencing
deflation at any time during the next 12 months to be so close to
zero as to not be worth considering and that the probability of Dollar
depreciation due to inflation was very high. The probability of
deflation is now even lower (if that is possible).
Many people automatically associate
falling asset prices with deflation, but such thinking is flawed. The linking
of falling asset prices and deflation caused many analysts to conclude,
during the Asian financial crisis of 1997-1998, that the "tiger" economies
of South-East Asia were experiencing deflation. This was a complete misread
of the situation. The countries involved in the crisis, with the exception
of Hong Kong, experienced rampant inflation during this period (their money
supplies were expanding at a rapid pace). The effects of this inflation
were not evident in the prices of assets, but they were evident in the
prices of gold and other commodities in local currency terms. The prices
of assets are determined by the investment demand for those assets and
a change in the money stock is only one of the influences on that investment
demand.
An inflation policy was pursued throughout
South-East Asia despite the fact that a lot of the region's debts were
denominated in US Dollars. Inflation, in this case, was therefore unable
to provide even temporary relief since it acted to increase the
debt burden (as the local currencies depreciated the US Dollar-denominated
debts presented an even bigger problem). The US of today, however, has
the advantage that its debts are denominated in a currency that can be
manufactured by its banking system. As such, inflation might provide temporary
relief. At least, that is probably what those responsible for framing monetary
policy will think.
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