Commodities | Aug 13 2008
By Greg Peel
Consider the following chart:
In mid-2007 the possibilities of a credit crunch were just beginning to make themselves apparent, but the frustration for gold bulls was that central banks were unloading metal into the market to shore up their own economies. When possibility turned to reality however, central banks could no longer hold back the tide. As the graph shows, the gold price hit the accelerator when Wave I of the credit crunch hit, catching back up to its trendline.
There was a stall at Christmas when it was thought the worst was over, but that didn’t last long. As Bear Stearns went down in Wave II, the US dollar hit its lows and gold rang the bell at over US$1000/oz.
But the market had talked itself up to US$1000, and it was all too much, too fast. So gold fell back to the trendline to begin a more orderly rise – a rise assisted by the implosions of Fannie & Freddie. However, there was one problem – the US dollar wasn’t behaving itself.
What greater impetus could there be for the US dollar to drop like a stone than news the US government would move to socialise Fannie & Freddie if it had to, using money it didn’t have? This along with the indefinitely open “emergency windows” provided by the Fed. Yet the US dollar did not fall. The dollar didn’t fall because no one was game enough to push the euro through US$1.60 – to beyond the point at which the G7 had threatened global intervention to prop up the world’s reserve currency. Soon the gold bulls began to lose their conviction.
Then the US dollar did a very strange thing – it began to rally. Not only did it rally, it rallied very sharply. At first there was a growing feeling the Fed might actually raise its cash rate, but ultimately the dollar rallied because the currencies of its major trading partners began to fall, and fall heavily. The great manufacturing economy of Europe had turned, Japan had all but announced a new recession, and China also showed signs of slowing. On fears of falling demand, commodity prices crashed. And so did the currencies of commodity producing economies. The US dollar is not stronger, it’s just that everyone else is now weaker.
The bounce in the US dollar appears to have halted a slide that began seven years ago, when 9/11 followed the tech-wreck. As the Fed cut its cash rate to 1%, the US dollar weakened, and it continued to weaken as spend-frenzied Americans blew out the US current account deficit against the likes of Germany, Japan and particularly China. The inevitable credit crunch that followed only accelerated the fall. The Fed went back into drastic cutting mode.
No other economy made such drastic interest rate cuts. For the world was happy to convince itself this credit crunch thing was an American thing, of America’s own making, and the rest of the world had since moved away from dependence on the US economy. That’s why the US dollar fell – because exchange rates are merely relative. It’s a new story now, however, as the rest of the world was wrong. It may have taken twelve months, but the global economy is now rapidly slowing. In order to return to exchange rate equilibrium, the currencies of the rest of the world have fallen, thus pushing the US dollar up.
And gold down.
But America’s woes are far from over. Indeed, they just seem to get more woeful every day. One would have to believe that gold’s fall towards US$800 has been as sharp as its rise though US$1000 was, and so it should soon attempt to make its way back to the trendline. Fair enough, but the above graph shows only the 2-year trendline. Here’s the ten-year:
Hmmm.
The London Daily Telegraph’s master of gloom – Ambrose Evans-Pritchard – cites four reasons for gold’s recent demise. Firstly, there is the catch-up weakness of world economies, as described above (Evans-Pritchard notes that the US is the only G7 economy that is not yet actually in, or on the cusp of a recession).
Thereafter he notes that gold has fallen as the commodity super-cycle has hit the skids, driven by global economic weakness, and that the inflation spike of early 2008 (food and oil) was driven by the “loose money” of previous years and was thus “vastly exaggerated” in the OECD economies. Those economies make up 60% of the world economy.
Finally, Evans-Pritchard suggests, no one could really care less about Georgia.
“So have we reached the moment when gold bugs must start questioning their deepest assumptions,” he asks. “Have they bought too deeply into the ‘dollar-collapse/M3 monetary bubble’ tale, ignoring all the other moving parts in the complex global system?”
The good news is, he thinks not.
Evans-Pritchard has long been a doomsayer on the survival of the European Monetary Union. When the member currencies were fixed – in perpetuity – in 1995 (prior to the actual launch of the “euro”) there was monetary convergence amongst economies. But they have diverged ever since. There is now a major rift between the big export economies of the north (particularly Germany) and the big current account deficit economies of the south (Spain, Greece). The south is now massively dependent on capital inflows from the north to plug the current account gaps. But these flows have stopped.
The central banks of Asia, the Middle East and Russia have been shifting their foreign reserves away from traditional reserve currency investment (US dollar) and into euro – as a supposed “twin pillar” – and thumbed their noses at the Americans on the way. But as Pritchard-Evans explains, the euro is not the dollar.
The euro has no European government, or tax, or social security system behind it. Each member remains sovereign in their own right (and each hates the other). “We are about to find out whether the EMU really has the levels of political solidarity of a nation,” he suggests, “the kind that hold’s America’s currency union together through storms”.
Suffice to say, he thinks not. Evans-Pritchard is awaiting European political unrest, in the face of growing unemployment across the continent and impotent monetary control out of Frankfurt. He is also awaiting a European “Bear Stearns”. But while the Fed had the power to save Bear Sterns, the ECB is prohibited from conducting bail-outs. All the European Central Bank can do is opt for a weak euro policy, or face destruction.
We will soon see a “race to the bottom” between all major global currencies, Evans-Pritchard suggests. Both the “pillars” of the global monetary system (dollar, euro) are unstable, “infested with the dry rot of excess debt”.
And that leaves only one “currency”.
“Gold bugs,” says Evans-Pritchard, “you ain’t seen nothing yet. Gold at $800 looks like a bargain in the new world currency disorder”.