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Establishing a Stable Dollar Is More Important Than Ever

The full version of our analysis (with comments particularly valuable for Precious Metals Traders) is available to our Subscribers.

In a move to boost a "disappointingly slow" economic recovery, the Fed has finally announced that it will buy $600 billion of US government months over an eight month period to lower interest rates and encourage more borrowing. In addition to this announcement, the Federal Reserve also made it clear that it is ready to do more if growth isn't achieved in the months ahead.

Policy makers in emerging markets have criticized QE2 (second round of quantitative easing), saying that pumping more money into the US economy will escalate the influx of cash in fast-growing developing economies. From South Korea to Brazil, officials have said that they intend to curb the flood of money going to their economy - to protect their export and to avoid asset price bubbles.

Within the United States itself, there are various concerns. This is because although the move is intended to boost growth, its concept is founded on shaky grounds: that manipulating the dollar can lead to economic growth and employment. The experience from the last 40 years has shown that markets may react the opposite way.

Establishing a stable dollar value by restoring dollar-gold convertibility may be the best way for the Fed to accomplish its goals of price stability and employment. It is important to compare the era before the "floating dollar" to today to get a glimpse of how glaring their differences are.


Analyzing the Gold Standard

An analysis of the past showed that from 1947 up until 1967, unemployment rate in the United States averaged 4.7% and it never went higher than 7%. Real growth rate was around 4% a year. There was also low inflation during this period - consumer-price inflation averaged 1.9% annually. Meanwhile, interest rates were also low and the yield on triple-A corporate bonds averaged 4% and never went higher than 6%. The above scenario was an era before the US turned its back on dollar-gold convertibility.

In 1971, after finally breaking the link between dollar and gold, the US experienced slower growth, decline in economic resilience, greater instability, and higher average unemployment. From 1971 until 2009, the jobless rate averaged 6.2% which is 1.5 percentage points higher than the previous decades. In addition, real growth rate was placed at 3%. Aside from these, the US also underwent the three worst recessions since the Second World War. In 1975, unemployment averaged 8.5%; in 1982, it was at 9.7%, and for the last 14 months to today, it is placed at 9.5%.

In the years that the Federal Reserve was allowed to manipulate the currency, consumer-price index, on average, increased by 4.4% each year. This means that one dollar today is only worth a sixth of what it was before. Interest rates have also become highly volatile. The yields on triple-A corporate bonds significantly increased to 8% and it never got lower than 6% until 2003. These developments are merely manifestations of monetary uncertainly. The economy has become less resilient to external shocks - leading from one financial crisis to another.

Also as a result of discretionary monetary policies, the world experienced more than 10 financial crises. As early as 1973, there was already the oil crisis. It was followed by several other major incidents, the Asian financial crisis, and finally, the economic crisis of 2008-2009. In addition, the threat of global currency war still looms - making 2010 and beyond look even bleaker for investors that haven't discovered gold and silver yet (they will, but at much higher prices).


Unfulfilled Promises of the US Dollar

At the center of these problems is gyrating currency value of the US dollar either in real terms (products and services) or in foreign-exchange markets. Because it can swing dramatically in either direction, windfall profits and losses are produced. The cycle feeds market speculation. Seeing the vulnerabilities of the dollar today, investors are finally putting their money back to gold and other commodities in the hope that it can hold its value amid FOMC's plan to decrease American buying power even further.

It should be noted that the "floating dollar" was well-received before because of the promise that it will improve the country's trade balance and make the labor force more competitive. Everything turned out exactly the opposite of what has been hoped for. In 1967, a dollar is worth approximately 2.4 euros (based on the German mark) and around 362 yen. 42 years on, the US dollar is devalued 72% against the euro and at around the same rate (at 75%) against the Japanese yen. And instead of gaining a surplus, the economy has a $390 billion deficit of GDP today.

Similar to their predecessors, FOMC are trying to find the best solution possible. But a glance at the past reveals that they might be going the wrong way about it. Federal-funds rate have been almost zero for nearly two years. Yet, businesses find it difficult to get loans from banks and other institutions. Savers are getting severely punished for being frugal because of the artificially low interest rates. Given that returning to the gold standard is not a plausible option at this point, the clear answer is still to increase the inflation rate. As we said in a previous article, however, this needs to be from demand-pull inflation rather than cost-push inflation to be effective.


Long Term Gold Chart

Gold

This week's long-term chart (courtesy of stockcharts.com) reveals that gold did not move above the upper limit of the long term trading channel. In a previous premium update, we said that some consolidation was expected. Is more to be expected? At this time, there is not enough information to make a call. Looking at the solid blue lines, the breakout in the upper limit is likely to be followed by a move to $1,500 in the succeeding months. Until this breakout appears, gold may not move significantly.


Gold Bulls See Gold Hitting $10,000

The idea of gold hitting $10,000 seems impossible at first glance but Shayne McGuire believes that it can happen. Shayne McGuire runs the Teacher Retirement System of Texas and handles a $330 million gold portfolio. While Wall Street analysts consider this claim outlandish (we believe gold could easily go above $6,000 and silver above $100), Mr. McGuire sticks to his claim. And he provides reasons to back it up.

Back in 2007, the 44-year-old pension-fund-manager and a colleague persuaded the $100 billion Texas fund to invest in the precious metal. It was a novel strategy at the time. Mr. McGuire called gold "the most under-owned major asset, widely seen as an eccentric, anachronistic leftover from the pre-information age that is best for 'end of the world' types." At the time, gold was valued at around $650, half its current price.

The precious metal's historic round-up is boosted by fears of inflation, uncertainties about currencies, and further monetary easing by the Fed. However, not everyone is impressed with gold. Billionaire investor Warren Buffet said that "It doesn't do anything but cost you charges and stare at you" in a recent interview. Indeed, the value of gold is hard to gauge because it produces no revenue and even costs money to store.

Despite all these, there is no doubt that gold will continue to be on an uptrend. Other gold bulls such as John Paulson predict that gold can go up by as much as $4,000 an ounce in 2013. For his part, Mr. McGuire said that gold can reach $10,000 if big investors and pension funds start to move as little as 1% of their assets (bonds and global stocks) to gold. This demand will contribute to the metal's rising prices. Combined with inflation, these developments can push the price of the precious metal tenfold from its current level. And then there is China which sees gold as a "basic savings asset."

Another reason why gold prices might continue to rise is the popularity of exchange-traded funds (ETF). These funds track an index but they are still traded like stocks. GLD, the largest ETF now invests $50 billion. It can go even higher if more investors move a percentage of their portfolio into gold. Right now, the total stock-market capitalization of gold ETF is placed at $80 billion, around the same as McDonald's Corp.

According to Mr. McGuire, "Now that the value of modern money is becoming highly questionable, more and more people are turning to gold. It's not the new thing; it's a return to normal." He further added that his prediction might seem aggressive (in fact, it is the most aggressive call he made to date) but that "it's really a comment on what governments have been doing to the monetary system."

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