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Gold US$ Dance on Again

It has often been shown that the Gold is the inverse of the US$. The best example of this was the 1970's when the US$ began a long downward spiral. If one recalls the best part of the move in gold was from 1976 to 1980 when at the same time the US$ was falling precipitously. After that Gold and the US$ switched positions and as gold fell the US$ rose into 1985. The next 15 years wasn't quite as clear but generally the same process was followed that as the US$ fell gold rose and vice versa. When the US$ bottomed in 1995 gold delayed its top until early 1996. Gold then fell hard into it double bottom lows in 1999 and 2001. Our monthly chart of the US$ and Gold show this dance that is quite remarkable for its consistency.

The US$ topped out in 2001 just over 121 while Gold was making a secondary low near US$255. Since then the US$ Index has fallen just over 30% to under 85 while Gold has climbed about $180 or 70%. So why do Gold and the US$ have such a symbiotic relationship. The US$ is the world's reserve currency. At one time the US$ was as good as gold as it was fully convertible into Gold at a rate of $35/oz. But in 1971 with billions of dollars of US currency floating around the world former President Richard Nixon closed the Gold window setting the US$ free to float against other currencies.

Of course now the US$ is backed by nothing but promises from the US Government that the paper money issued will be acceptable currency. Indeed there is virtually nothing to stop them from changing it tomorrow if they wanted to. This is known as fiat currency and over the course of history there have been numerous periods of fiat currency. Governments looking for ways to expand credit issuance in order to pay for wars have often used periods of fiat currency. This period of the fiat currency is no different, as the wars have moved from Vietnam, the Cold War and today to the War on Terror and Iraq.

The thirty years plus since the collapse of the gold standard has seen the biggest credit expansion ever recorded not only for governments but as well for corporations and especially for consumers. The consumer society of Western Civilization owes itself to coming off the gold standard and the massive credit expansion. With a gold standard governments and the banking system would be severely constrained in their ability to expand credit. It is well known that the private banking sector in particular has little use for a gold standard.

With the US running huge budget and trade deficits today totaling now roughly $1 trillion/year the US$ has been falling against other currencies. When other countries that are not reserve currencies run huge budget and trade deficits their currency can be devalued quite viciously. Think of Argentina, Mexico, Turkey and Russia that have gone through difficult currency devaluations over the past decade and as a result seen their economies collapse. The collapse of then little watched Thailand Bhatt that eventually spread to other Asian countries originally caused the Asian flu crisis. But when that happens to other countries it is the people of that particular country that suffer and they wind up as a basket case for the International Monetary Fund (IMF).

It has taken some time but now the US$ is facing the same crisis that has hit many a third world country. Only problem is the US$ is the world's reserve currency so a devaluation of the US$ has ramifications not just for the people of the US but also for the world's financial system. As we noted at the outset the US$ has gone through three major periods of devaluation since it was set to float in 1971. The first one was the 1970's and the second one occurred from 1985 to 1992/1995. This is the third time the US Dollar has embarked on a major devaluation.

At the height of the 1995 crisis there was some concern about the entire financial system especially when in 1994 the bond market embarked on one of its biggest collapses ever. But it set in motion the Clinton administration's strong dollar policy and from 1995 to 2001 it worked.  Indeed it worked so well it was part of the package that set in motion the great bubble of the late 1990's as the Japanese Yen was devalued and Japan started to re-liquefy its financial system with low interest rates and huge monetary growth. The US was similar as money supply growth that had been largely flat through the early 1990's exploded to levels of 10% or more annual growth. The huge infusion of money coupled with the low interest rates in Japan set in motion all sorts of carry trades to take advantage of what everyone knew was a couldn't lose proposition.

But nothing lasts forever and it was necessary to prick the financial bubble it caused back in the late 1990's. The attack on September 11, 2001 set in motion another period of massive monetary stimulation coupled with low interest rates that contributed to the secondary bubble we are seeing now. This bubble has largely gone into real estate and to a lesser extent the stock market which is now embarking on what could be a blow off top. The strong dollar policy encouraged massive trade deficits couple this with the huge budgetary deficits and these further stimulated the economy. But the Bush administration abandoned the strong US$ policy of the Clinton administration and since then the dollar has been on a downswing.

Just after Bush won re-election for a second term the US$ fell to its lowest levels since it began its collapse back in July 2001. This of course is causing some grave concern in many other countries particularly Japan but also here in Canada where the Canadian Dollar has increased over 30% to 84 cents since January 2002. While Gold in Cdn$ is also up over the past several months the rise in Gold has been offset by basically an equivalent rise in the value of the Cdn$ resulting in flat prices for Gold in Cdn$. We do not expect that to continue, however, and at some point Gold will rise in Cdn$ as well.

There are numerous pundits who see nothing wrong with a falling dollar and running large trade deficits and budget deficits. Their rationale is that the US is the world's largest economy and the leading one. That leadership is unassailable and running deficits is not a problem. The budget deficits are important stimulus at a time they need stimulus and the trade deficit is merely a recycling of dollars problem. They believe that most countries would not desert the recycling of dollars because if the US fell into a deep recession it would impact them negatively as well. So they don't think it is the calamitous issue many believe it is. Indeed some claim that the dollar and depression bears are just hysterical and not even worthy of paying attention to. A lower dollar will help US manufacturers and since a lot of goods are made in China as long as China maintains a fixed currency to the US$ Chinese goods will remain cheap for Americans. Further most large US corporations are multinationals and a fall in revenues in one country is offset by increased revenue in other countries.

But the big fear is that foreign investors will eventually get very nervous about a rapidly falling US$ and begin to yank out investments or diversify into other currencies. Already we are seeing signs of that China is trying to diversify its foreign reserves into Euros or gold while switching investments to other countries like their recent announced interest in Canada's Noranda Mines. Russia as well is trying to diversify further and they too have an interest in Canada. There has been considerable talk (but little action) in asking for payment for oil in Euros. Russia has been looking at it particularly since they import largely to the European zone.

Even the Federal Reserve is becoming concerned. A recently released report from the New York Federal Reserve expressed concern over the huge increase in reserve holdings of Foreign Central Banks held with the Federal Reserve. Reserve holdings are largely in US$ Bonds and Treasury Bills but also agency paper such as Fannie Mae (FNM-NYSE) and Freddie Mac (FRE-NYSE). Levels have reached over $3trillion over double what was held in 1995. While these purchases have gone a long way to offsetting the trade deficits there is concern especially over the huge holdings by Asian Central Banks (primarily Japan and China). The concern was that the huge holdings by foreign Central Banks could lead to a combination of "lower asset prices, higher interest rates and a weaker dollar". The report of course by the Federal Reserve was in carefully measured language.

The truth is that few countries can withstand massive ongoing currency devaluation. Eventually it impacts inflation, raises interest rates and depreciates assets. The US could help its own cause by sharply reducing its deficits. This is not likely to happen very soon as the need to finance the war effort makes deficit financing a given. Oddly one needs to be reminded that one of the prime reasons the Russian empire collapsed was that they were unable to withstand the currency devaluation that came with the massive budget deficits as a result of its financing of war efforts in Afghanistan and the Cold War.

Some countries are happy with a falling US Dollar. China for one fixes the Yuan to the US$ and has little incentive to release the peg. If they did it would make Chinese goods more expensive in the US and could impact negatively their strong growth. Still the recent hike in interest rates in China may be start towards decoupling the two currencies. But we are reminded that for all China's huge growth the country still has a weak banking system and much needed financial reforms lie unfulfilled. China has never had a real collapse since they embarked on the strong growth period in the 1990's. But developing capitalisms like China are highly susceptible to a financial collapse because of the excesses of speculation the high growth encourages. Just because it hasn't happened doesn't mean it won't happen.

With a weak dollar policy almost entrenched in the Bush administration we find it odd that they have also pledged to balance or at least reduce the budget deficit. We don't believe them because to do so would require hire taxes, which the Bush administration will not do. The big danger with the falling US$ is that everyone really gets nervous and there is a panic. Trying to determine what might cause a panic is very difficult but one thing we have been following in the background is what is being called "Votergate", allegations of voter fraud in the recent US elections. A quick summary of some of the issues is as follows:

Electronic voting machines with no paper trail - numerous reports of voters voting for Kerry only to note that it instead gave the vote to Bush; those that reported the problem had it fixed while many did not report whether they had a problem; more votes than there were registered voters occurred in numerous polls with Electronic voting machines; exit polls in Ohio and Florida did not agree with actual results; a number of counties in Florida that voted overwhelmingly Democrat in the 2000 elections went narrowly for Bush this time; this only occurred in counties using Electronic voting machines; numerous reports of preventing voters from voting through challenging registrations and other shenanigans; numerous reports of provisional votes not tallied despite requests to do so; the mysterious lockdown by the FBI of a some Ohio counties barring observers for the count on the basis that they might have a terrorist attack; These were rural counties and again it was only in those that had Electronic voting machines; Keith Oblermann raised the issue in a recent show on MSNBC. The video can be found at www.truthout.org/multimedia.htm.

Obviously we have no idea whether this has any legs or not. Given the number of stories we have seen, however, we do know that it is not a conspiracy and that they are serious allegations. The two states that are primarily involved are Florida and Ohio, two states that were supposed to be too close to call during the recent election and that for one in particular, Ohio had polls that showed it should go to Kerry. Instead, Bush won by a very small plurality of just over 100 thousand votes. 

The US$ has technical targets down to 60/65. Today the US$ is still higher than its all time lows in 1992 of just above 78 a year after the US last posted a small trade surplus. Today the trade deficit is approaching $600 billion. Considerably lower values in the US$ will lead to higher gold prices. It emphasizes that investors should ensure that they have at least 10%-15% of their portfolio in gold stocks and at least 5% held in bullion. The best way to hold bullion is through the Millennium BullionFund (www.bmsinc.ca, 905-474-1001, 1-888-474-1001) an open ended mutual fund trust (note: I am a director of Bullion Management Services, the manager of the Millennium BullionFund).

Silver prices will also benefit from rising gold prices as years of very low silver prices have eaten away at supplies and no new mines have been started. Silver is targeted for $12/$14 over the next several months as Gold should rise to $480/$500.

The US$/Gold dance has a long history. Investors would be foolish to ignore it.

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