Below is an extract from a commentary originally posted at www.speculative-investor.com on 6th May 2007.

The argument put forward by most US$ bears can be summarised as follows: Due to the large US current account deficit the dollar is destined to move much lower and, in fact, would already have plummeted to new multi-decade lows if not for the support provided over the past two years by favourable interest rate differentials. But the dollar's interest rate advantage is set to evaporate over the coming months as the Fed cuts rates in reaction to the housing-led US economic downturn while the ECB continues to push rates upward in reaction to Europe's strengthening economy. As a result, a major US$ breakdown is imminent.

Our view, however, differs from this conventional bearish wisdom. In particular, in commentaries over the years -- most recently in the 11th April 2007 Interim Update -- we've explained why a large current account deficit is not, in itself, a reason to be bearish on a currency.

The only aspect of the aforementioned bearish argument that rings true to us is the part about interest rates lending support to the dollar over the past two years. Note, though, that while interest rate differentials are important drivers of intermediate-term currency market trends they tend to operate with substantial time delays; so even if the dollar were to immediately lose its interest rate advantage over the euro this would probably not cause USD/EUR to move lower over the next 6 months. In any case, almost regardless of what happens in the housing market there is little chance of the Fed cutting the overnight target rate with gold hovering around $700/ounce and the global stock market rally in full swing. Actually, if gold moves up to test its May-2006 peak in the near future while cyclical assets such as equities and industrial commodities remain strong then the Fed's next move will most likely be a rate HIKE.

Those who are expecting the US$ to move much lower relative to the euro are, we think, making two logical errors (in this discussion we'll focus on the US$ relative to the euro because the euro is the other senior currency and because USD/EUR comprises almost 60% of the Dollar Index). As mentioned above and as discussed numerous times in the past, the first is to assume that a large current account deficit will necessarily translate into currency weakness. The second is to assume that the euro is somehow a harder/sounder currency than the dollar.

In our opinion, the euro is the ultimate fiat currency in the worst possible way. Whereas the dollar started out as a genuinely hard currency (a US dollar was originally a measure of gold) and evolved into a shadow of its former self over many generations, the euro has never been anything more than a political concoction (it began life as a shadow). Whereas the dollar was literally as good as gold at one point in the distant past, the euro has never been backed by anything more tangible than confidence*.

So, if the current-account situation is not a primary driver of exchange rate trends and the euro is inherently no better than the dollar, then what should we be focusing on?

The answer is that the main long-term driver of currency exchange rates is the differences in the rates at which currencies lose purchasing power; and this, in turn, is primarily determined by differences in money-supply growth rates.

Due to the relatively high rate of growth in its supply during 1998-2002 the US$ began to lose purchasing power at a faster rate than the euro, leading to the long-term decline in the USD/EUR exchange rate that began in January-2002. But while the dollar appears to have lost less value relative to some currencies -- the Yuan and the Yen, for instance -- than would be justified by changes in purchasing power, it seems to have lost way too much value relative to the euro. Changes in purchasing power cannot be measured on an economy-wide basis so it is not possible to come up with a single number that represents the euro's excess value, but anecdotal evidence -- for example, the fact that Europeans are flocking to the US to shop -- suggests that the euro is presently trading at a premium of at least 20% to where it SHOULD be trading based on purchasing-power-parity considerations.

Had the supply of dollars continued to grow at a RELATIVELY fast rate then it might be reasonable to expect the closing of the purchasing power gap between the US and Europe to be driven by higher prices within the US rather than by a rally in the US$ relative to the euro. However, from the final quarter of 2003 through to the end of 2005 the total supply of US dollars consistently grew at a SLOWER rate than the total supply of euros. This set the stage for a dollar rally, but note that there is often a substantial delay -- at least 1 year and perhaps has much as 4 years -- between a major change in the money-supply growth trend and the effects of this change becoming evident in purchasing power and the foreign exchange market.

The following chart of US M3 money supply shows that the period of moderate dollar-supply growth ended in the final quarter of 2005. The rate of growth in the total supply of dollars then accelerated, but this is not a good reason to be bearish on the dollar relative to the euro because something similar happened to the euro supply. In fact, the supplies of most of the world's fiat currencies are now growing rapidly (the supplies of US dollars, euros, Australian dollars, Canadian dollars and British Pounds have expanded by 11%-14% over the past 12 months). Trying to pick the strongest of this group of currencies is therefore like trying to pick the smartest of a bunch of village idiots.

Chart source: http://www.nowandfutures.com/key_stats.html

In summary, the euro is very over-valued relative to the US$ at this time and neither money supply nor interest rate considerations support the continuation of this premium. We therefore expect the US$ to be trading at a substantially higher level relative to the euro at the end of this year than it is today.

This currency market view does not, however, automatically mean that we expect the US$ to move higher relative to gold. While a multi-month advance in the US$ relative to the euro would normally translate into a lower US$ gold price, we are anticipating an up-move in USD/EUR driven more by euro weakness rather than by genuine US$ strength. Such an outcome could coincide with gold rising in terms of all currencies, but rising less in US$ terms than in euro terms.

*The ECB has 20.6M ounces of gold in its currency reserves, but the current market value of this gold is equivalent to only 0.13% of total euro supply. The US$ has a marginally higher 'gold backing' in that the current market value of the US's 262.8M-ounce gold reserve is equivalent to around 1.5% of total dollar supply. In both cases the gold reserve is trivial compared to total money supply and doesn't constitute 'gold backing' in any meaningful way.