THE U.S. DOLLARS: OVER OWNED AND OVER VALUED By John Hathaway
"A speech delivered at the 2000 Mining Investment Forum. A bear
market in the dollar seems around the corner. This should
stimulate investment demand for gold."
I invest in gold shares for a living. I manage a gold sector
mutual fund. Despite this, I do not long for a return to the
gold standard or wish to prescribe any particular solution for
this or that economic ill. I am not as captivated as some by
geological speculations. The finer points of mine engineering or
nifty metallurgical nuances disinterest me unless they pertain
directly to value creation in our portfolios. The painstaking
bean counting necessary to construct supply and demand models
for the gold market does not dazzle me. The promotion of gold as
jewelry and the liberalization of Asian retail markets are
constructive, I suppose, but in the final analysis do little to
form a rationale for investing in the sector. Finally, I am not
caught up in conspiracy theories. None of the foregoing
considerations, it seems to me, add up to a money making
proposition.
Why then, you must be asking, would I be doing this? I see gold
as a way to reap a tidy profit on impending changes in the
financial landscape. It is a speculation against financial
assets, against the preeminence of the US Dollar, and against
the financial market speculation that has raised dollar to its
untenable, almighty stature.
I am only interested because of the possibility that gold might,
within a reasonable time frame, i.e., in my lifetime, trade at
$500 or even $5000/ounce. A breakout, to say $325, which we
would all enjoy, would be hardly worth the expenditure, the
investment, or the time it has taken for such a paltry result.
Gold is a potentially huge score. What keeps me interested in
this wasteland barren of investment returns are the positive
macro economic trends for gold. There are encouraging signs that
the high water mark has passed for the dollar, financial assets,
and the credit boom that has fueled the bull market in paper and
the bear market in gold.
HEDGING, DERIVATES, THE SHORT INTEREST, AND CONSPIRACY
For the most part, these considerations are ancillary to the
main thrust of my investment reasoning. However, it is worth
spending a minute or two to the extent that they can shed light
on the structure of the gold market. At best, these factors will
lead to periodic short covering rallies. By themselves, their
existence will not attract speculative capital to this arena.
The existence of a large and vulnerable target in the form of an
outsized short interest will help propel the gold price once the
dollar is under attack. Conspiracy, in my opinion, is too strong
a word for what is going on in the gold market. However, it
should surprise no one that some form of manipulation is taking
place. Governments routinely intervene in the currency markets.
Gold is a form of currency. As stated by Professor Robert
Mundell, Nobel Price Winner, gold is subject to a lot of
elements of instability, not the least of which is the attempt
on the part of several big governments to make it unstable.;
Mundell made these comments at the World Gold Councils 1999 Fall
Symposium in Paris, at which he was the honored guest.
Since World War II, various governments, and especially the
United States, have steadily moved in the direction of
marginalizing gold as a reserve asset. At different points in
time, these efforts have been coordinated among several
governments, although the motivations among the various
participants have not always been consonant. The first notable
example of such activity was the London Gold Pool, a joint
effort by the United States and several European governments to
depress the free market price of gold to disguise the growing
weakness of the US dollar. This effort lasted over a decade,
from the mid 1950,s to 1968. At no time during the pools
operations was there any advance official acknowledgement that
such operations were being conducted. Market players were kept
in the dark. However, speculators were able to infer the pools
existence from the price behavior of gold, figures on US gold
reserve assets, and the balance of payments. As a result of the
pools activities, substantial economic interests arose which
would win or lose depending on its success in depressing the
gold price. As time passed, the incentives of all participants
to keep the free market price of gold at $35/oz diverged, most
notably France. Once national economic interests diverged,
increasing flows of speculative capital mobilized and ultimately
defeated the government scheme. Fortunes were made at the
expense of taxpayers, especially US taxpayers.
Since the early days of the Clinton administration, the
tradition of manipulating the free market gold price has been
honored. As with the gold pool, the actual origins are probably
obscure. While far more complex, current Anglo-American led
efforts to depress the price have one very important similarity
to the gold pool. The financial stakes of public and private
market participants are huge. These interests extend well beyond
the immediate gold market.
There is no better illustration than the panic in government and
private circles that was touched off by the Washington
Agreement. Central bank officials appeared to be clueless as to
the structure of the gold market, especially as to the size and
location of the short position that had been required to keep
the gold price locked in a downtrend. They were horrified by the
volatility of the gold price in the following days, and of the
potential damage to bullion dealers, many of whom were also
major international banks (see JP Morgan To The Rescue? ( for
more detail). The crisis galvanized the central banking
community into quick action to provide liquidity for the gold
market, which was about to vaporize. The provision of liquidity
in the moment of crisis emboldened dealers to expand positions.
As noted by Reginald Howe (The Golden Sextant), the mysterious
Exchange Stabilization Fund, managed by the US Treasury, lost
$1.6 billion during the 4th calendar quarter, more than it
earned in all of 1999. After this near death experience, it is
likely the official sectors resolve to keep gold in the deep
freeze was reinforced. The continuing expansion of dealer
derivative positions despite declining producer hedging, and
especially the lengthening of maturities reported in the BIS and
OCC numbers, suggest renewed conviction among dealers that
divine assistance will never be too far away in time or price.
At the same time, the Washington Agreement marks a watershed for
the gold market. Even though central bankers worked together to
end the crisis, the interests of the Europeans and the
Anglo/American camps with respect to gold may have started to
diverge. This is despite the fact that Europeans bankers
continue to be persuaded by bullion dealers into active
management of their gold reserves, (i.e., leasing and
dispositions to invest in interest bearing securities including,
Euro denominated.) It is also despite the fact the US and
Britain were signatories to the agreement, an act they may have
found distasteful. The Agreement marks the first step towards
the reinstatement of gold as a monetary reserve asset. If the
Euro continues to have problems, the Europeans will figure out
that there is little advantage to trashing their largest reserve
asset other than dollars. Professor Mundell has suggested that
the European Central Banks issue gold coins as part of this
current intervention: The production of a gold currency would
heighten general interest in the euro and at the same time put
the excess gold reserves to good use.
At the end of the day, these structural considerations are
interesting for two reasons. First, they are necessary to
understand what has already transpired in the gold market. More
important, they shed light on the massive misallocation of
investment capital. The continued existence of a large short
interest, which is impossible to cover other than from longer
term deliveries from new mine production or official sector
sales, increases the potential upside move in gold.
THE CLINTON DOLLAR
The case for renewed investment interest in gold centers on the
proposition that the US dollar is at or near its peak. Should
this be the case, investment flows will seek out alternatives,
including gold. The dollar is the unrivaled instrument of
international credit and capital flows. It is the foundation for
most commercial and financial market transactions. The
perception that the dollar is a store of value as well as a
medium of exchange explains the willingness of governments,
businesses and individuals worldwide to hold dollar instruments
to the near exclusion of alternatives. However, it was not
always so.
During the early 1960s, 1970s and 1980s, the US dollar was
suspect. In the 1960s & 8217s, the most obvious flaw was a
deteriorating balance of payments position. Other indicators
such as inflation, interest rates, and equity markets were
favorable or benign. The geopolitical situation, however, was
dicey. It was not entirely clear that capitalism and the US
would ultimately prevail over the competing forces of communism
and the Soviet bloc. The gold pool attempted to disguise the
dollars chronic weakness by depressing the free market price of
gold.
In complete contrast, the Clinton/Rubin/Summers dollar is beyond
reproach and is almost universally admired. At the recent
Financial Times gold conference in June, central bankers openly
worried about the future of gold, but never voiced concern as to
their potentially imprudent concentration in US dollars. The
possibility that US budget surpluses would shrink the supply of
government debt was openly mourned, despite the fact that OMB
projections show no such shrinkage. These projections, found on
the OMB web site, show government debt increasing in every year
through 2012, as far out as the projections go. Still, the rage
among these seemingly ill informed central bankers is a
pronounced preference for interest earning paper assets to
stagnant bars of bullion. And the preferred paper asset by far
is the US Dollar, which represents 77.7% of world central bank
reserves, according to the latest BIS annual report. The
percentage is certainly disproportionate to the US share of
world trade and economic activity.
The US trade deficit will reach 4.3% of GDP this year, as noted
in a paper (Perspectives on OECD Economic Integration:
Implications for US Current Account Adjustment) presented to
world central bankers at the annual Jackson Hole symposium by
Professors Obstfeld and Rogoff. More important is the percentage
of US financial assets held abroad, $1.9 trillion or nearly 20%
on a net basis of GDP, the highest since the 1800s. They argue
that only a small percentage of GDP is ;tradable, the remainder
being explained by non-tradable components of GDP such as rent,
transportation, labor etc. The percentage of GDP that is
internationally traded, or readily redeemable for dollars held
abroad, may only be 20% to 25% of the total, suggesting a higher
rate of borrowing and a lower degree of national solvency than
is generally perceived. According to the professors,
critical issue in determining sustainability is not simply the
rate of borrowing, but accumulated debt. They assess the risks
of a dollar crash as significant. While not predicting such an
outcome, the study suggests that a sudden depreciation of
24%-40% could occur if foreigners moved quickly to exchange
their dollars.
The disproportionate ownership of the dollar is widespread
throughout numerous asset classes. According to Bridgewater
Daily Observations, gross foreign ownership of US assets now
measures over $6.4 trillion (66% of GDP). Foreigners own a
record 38% of the US treasury market, and 44% excluding Federal
Reserve holdings. They own a record 20% of the US corporate bond
market and 8% of the US equity market. What would a change of
sentiment on the dollar do to US asset prices?
Keep in mind that the dollars strength is only relative to the
Euro and the Yen, two seemingly unappealing alternatives.
Neither has been regarded as a serious rival, with their
shortcomings widely publicized. The integration of world
financial markets has eliminated many of the traditional safe
havens such as the d-mark or the Swiss franc. World capital
flows dwarf even the more liquid currencies. It seems as if it
has come down to the dollar or nothing at all. Nothing at all,
except for gold, which stands to become the protest vote on the
monetary ballot, the equivalent of none of the above.
The epic strength of the dollar is no longer something to
celebrate. The weakness of the Euro in particular has created
sufficient discomfort to trigger a round of concerted
multinational intervention. The interdependence of world
economies and financial markets means that the dollar cannot be
isolated or insulated. Whenever the foreign exchange markets
force the hand of central bankers, there is reason for us to
cheer. Interventions rarely work in the long term. Perhaps the
Euro will be viable, but there is no precedent for a successful
multinational currency. It was the prospect of the Euro in large
part that led European central bankers to view their reserve
assets, especially gold, as redundant.
It is possible that the Euro will turn out to be a fiasco,
notwithstanding the current rescue effort. Even though the
economic fundamentals of Europe are improving, that does not
assure success for this experimental, peculiar currency. The ECB
is issuing Euros at growth rate of 10% on a 12 month basis and
nearly 20% in recent months. Banana republic growth rates may
help explain the market&s aversion. An eventual abandonment of
the Euro would be bullish for gold and possibly bearish for the
dollar, but the demise of the Euro is not the only potential
source of renewed investment interest for the metal. Time and
space will not permit me than to do more than merely mention
some others:
-banking derivatives. The potential miscalculations in the gold
market are minuscule compared to the bets that have been placed
on the foreign exchange and interest rate markets. According to
the BIS, total derivatives on interest rates and currencies
measure in the hundreds of trillions.
-under investment in the commodity sector will lead to shortages
and spiraling prices in certain commodities. What is happening
in oil is a template for nearly all other basic resources. A
softening economy, favored by the bond vigilantes, will only
starve the resource sector of the necessary capital investment
to meet growing demand. The rise in commodity prices over the
past year is not a fluke.
-excessive investment in the high tech and telecommunications
sectors will lead to banking and bad loan problems reminiscent
of tanker loans, S&L defaults, real estate, and other similar
misadventures.
-the doctrine of just in time inventory management has resulted
in a run down of critical stocks of basic materials. Supply
shocks will evoke consumer responses similar to that recently
witnessed in Europe during the protests over high energy prices.
If the markets lose their confidence in deliverability, there
could be a secular swing towards restocking and hoarding.
-the over concentration in US financial assets. Recent
acquisitions of behemoth financial institutions by their foreign
counterparts are another sign of a market peak for financial
assets.
-a recession would undoubtedly trigger renewed monetary ease,
including lower interest rates and more rapid money growth.
-US equity prices seem to have peaked out, with no new highs in
the DJII, S&P, and NASDAQ Composite since the first quarter of
this year. Most stocks peaked out a year or more before the
averages.
-a bear market or a recession would depress tax revenues and
undermine the outlook for a budget surplus.
The dollar is potentially vulnerable on these and many other
fronts. It is vulnerable, because like an overvalued growth
stock, it is priced for perfection. It is vulnerable, because
like an overvalued growth stock, it is over owned. The inflation
news cannot remain rosy forever. The BLS reports on the CPI and
PPI are already viewed with suspicion. The concept of a core
inflation rate has become laughable. The idea that inflationary
threats can be stifled by high interest rates, restrictive money
growth, and tight fiscal policies seems questionable against
todays political and even geopolitical realities. The
productivity myth rests on the dubious foundation of hedonic
pricing methods, a methodology applied to the BLS price indices
at the beginning of the Clinton administration. Even the
Deutsche Bundesbank and OECD have recently challenged the
validity of this centerpiece of financial market lore. Using
this methodology, the BLS has inflated spending of $28 billion
by business on computer hardware, or 3% of nominal GDP growth,
to $127 billion or 20% (Richebacher Letter-Sept.2000) The impact
of these adjustments is a substantial overstatement of
productivity figures and an understatement of consumer price
inflation.
The policies and practices of the Clinton Administrations
Treasury department have established the dollar as the premier
currency. This exceptional high standing is essential to the low
inflation rate enjoyed in the US but not in the rest of the
world. A weaker dollar would hinder the access of the American
consumer to cheap foreign items and therefore lead to higher
inflation.
The dollar is high because of a successful and widespread
campaign across a number of fronts and the confluence of
external events that included:
-implementation of hedonic pricing methodology to BLS
statistics.
-widespread financial market reforms that encouraged banking
industry consolidation and the emergence of financial
institutions of unprecedented scale.
-removal of trade barriers
-curtailment of longer term treasury debt maturities
-endless spin on a strong dollar
-making sure gold did not establish an uptrend.
-the demise of the Soviet empire.
-the strong fiscal position of the US
There were probably a number of other contributors to this
strong dollar policy. These developments interacted with the
markets in a way that reinforced the dollars strength and
undermined gold. However these measures and/or events, like the
Clinton administration, will soon be history. The explanations
are similar to those associated with great growth stocks at
their peak valuations. They are easy to articulate in
retrospect, and there is a tendency by market participants to
extrapolate more of the same. However, we may have reached the
limits of the desirability of a strong dollar based on the
extreme position of our trade balance and foreign asset
ownership. The Euro intervention is a tip off that there is
sufficient disquiet in the public and private sector that a
change is in the wind.
The real clues to the outlook for gold lie in the market for the
US dollar. The Clinton administrations strong dollar campaign
has enjoyed wild success, creating an insatiable appetite for
the paper. This success is a principal reason for the dollars
present vulnerability. When will foreign holders of US assets
begin to suffer from buyers remorse and realize that the strong
dollar has gone too far? The fundamentals supporting a change of
opinion have been in place for some time and without a catalyst
could continue. Identifying a particular catalyst is very
tricky, but there seems little doubt that prospects for a change
of direction are promising.
John Hathaway
© Tocqueville Asset Management L.P.
September 2000
For general questions and comments reply to Info@tocqueville.com.
Tocqueville Asset Management
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New York, NY 10019
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