AGE Gold Commentary is our regular report analyzing trends in precious metals and rare coins. We monitor domestic and international markets and extrapolate from our 30 years in metals to place current events into a hard asset perspective. View archives.
4/23/2007: China trade and the dollar
Greetings from American Gold Exchange. In this issue of Gold Market Commentary:
Precious metals surging Precious metals surging
U.S. dollar falling
Back to the Bretton-Woods
China trade and the dollar
Recommended classic U.S. coins
Precious metals surging
In last month's update, the charts for gold, silver, and palladium were all very strong, and the chart for the U.S. dollar was very weak. These trends are continuing, with precious metals across the board heading to their highest points for the 2007. More importantly, the dollar is now probing new lows for the year and looks to weaken further. In this update, we explain why the U.S. dollar is likely (even destined) to fall further, and the explosive ramifications for precious metals if it does.
While the rising oil price and ongoing world tensions have been influencing precious metals recently, the declining value of the U.S. dollar has been their greatest and most lasting driver during this mega-bull market. Between 2001 and 2005, gold gained approximately 100% in price on the back the declining value of the U.S. dollar alone. Between 2005 and 2006, it gained 30% more, but primarily because of surging oil and escalating tension in Iraq, North Korea, and Iran. Since last summer, oil has channeled in price, international tension has waxed and waned repeatedly, and the U.S. dollar has channeled, too, until recently.
Today, however, the dollar is setting new lows for 2007 on the U.S. dollar index chart, and has recently set a new low against the euro and a 26-year low against the British pound. With the dollar acting perilously 'subprime' lately, precious metals may have a tangible reason to move substantially higher once more. Let's look at the latest precious metals charts and then we’ll discuss in more depth why the dollar is declining again.
As the current one-year gold chart shows, gold rebounded smartly after February's “Shanghai Surprise,” when the Chinese stock market plunged 9% and dragged most international assets, including gold, down with it. Riding strong fundamentals, gold is now ready to test the psychologically important $700 price barrier and perhaps the May 2006 high of $715 as well (represented by the red line across the top of the chart).
Despite the March pullback, gold remains within the upwardly moving, blue trend lines established by the trading highs and lows going back to October 2006. As we said last month, this chart continues to look very strong and further gains are likely.
The main characteristic that comes to mind in describing gold trading action in 2007 is resilient. When looking at the one-year gold chart, it's helpful to consider it as two six month periods in succession. The first six month pattern, leading into and following the May 2006 high, reveals a trading pattern of wild price movement as the market struggled to find direction following its period of greatest gain in decades. Once a strong double bottom was formed between $550 and $570 an ounce (a classic W pattern), gold began climbing again in classic bull market form.
In the last six months gold has begun to climb again in earnest. The first signal was the daily gold trading price moving back over the 50-day and 200-day moving averages in November 2006. Confirmation of gold's resumed climb came in early 2007 when the 50-day moving average crossed back over the 200-day moving average, while the daily gold trading price held well above both. Since then, gold has steadily stair-stepped higher. We continue to believe gold will move well above $750 on its next real run and probably test the $850 all-time high.
As you will, see the following charts for silver, platinum, palladium, and even oil reveal very similar trading patterns with slight variations.
The one-year silver chart is very similar to the gold chart, and also suggests further gains are likely. Following silver's strong break above $10 an ounce in the fall of 2005 and winter of 2006, and the consequent generational high of $14.92 in May of 2006, the first six months of this chart show a period of wild price swings. Like gold, silver formed a double W-shaped bottom and has stair-stepped steadily higher since.
Because it's been leading gold since May and has been more volatile, silver has already challenged its May 2006 high, just prior to the February Shanghai sell-off. And despite the sell-off, just like gold, silver remains firmly within the blue, parallel trading lines established by its daily trading price highs and lows.
We continue to believe silver will surge to over $20 on its next major run, and then consolidate a little lower but still over $18 per ounce.
The one-year chart above shows platinum trading in a similar pattern to gold and silver but lagging them slightly. Like gold and silver, platinum and palladium are both surging in price, but now they have an additional reason: the launch of new ETF funds based on the metals.
According to Reuters, “London-based ETF Securities said it would launch physically backed ETFs based on platinum, palladium, gold and silver on the London Stock Exchange on Tuesday. This followed Zurich Cantonal Bank's announcement that it planned to launch ETFs in platinum, palladium and silver by May 10."
It's difficult to say at this time to what degree ETF buying is influencing the platinum and palladium market. Because available above ground physical supplies of platinum and palladium are much smaller than those of gold and silver, strong short-term physical buying can push prices up sharply. Conversely, the sudden absence of heavy buying can lead to sharp sell-offs as well.
Platinum is now challenging its May 2006 high of $1,320 per ounce and further gains in the short term are likely. Be very careful if you are a speculator. Once short-term physical buying orders are filled, prices are likely to soften, perhaps sharply. Platinum remains the most volatile of the four traditional precious metals and is the most 'fully valued' at the current time, so we continue to favor silver, gold, and palladium over platinum for buy-and-hold investors.
The one-year palladium chart is very similar to the ones we have already discussed. The difference is palladium's recent, strong break over its blue trend lines established by the daily price highs and lows over the last six months.
Palladium is surging on the back of physical buying to support new ETF funds as mentioned above. When silver surged behind the introduction of its ETF (SLV) last year, it was unable to hold onto those gains in the short term, once the ETF funds had accumulated their physical holdings.
Palladium is now in break-out mode, suggesting further strong gains are likely. Keep in mind, though, that ETF fund buying remains a wild card at the moment. Palladium is likely to hit strong price resistance at its May 2006 high of just over $400. When it moves above this resistance point it will be in blue sky; prices of $500 and higher become probable, so we'll be watching it very closely. With the ETF now part of the pricing equation, we do anticipate greater than normal price volatility in palladium, so proceed with caution if you are a speculator. With its recent strength, it should enjoy solid support above the $355 to $360 range even if it does not break above $400 in the next few weeks.
Oil is once again moving higher despite its typical springtime weakness, and should enjoy strong support just under $58 per barrel (the green line). While oil's 50-day moving average has not yet crossed back over its 200-day moving average, that convergence seems only days if not weeks away.
U.S. dollar falling
While rising oil prices over the last five years have certainly given impetus to the bull market in precious metals, its most potent current driver is the relative unhealthiness of the U.S. dollar. The dollar was looking very weak when we issued our last update and has continued to drop precipitously since, setting new lows against both the euro and the British pound. Very quickly, the host of macro events we've been discussing for months – record U.S. trade and budget deficits, the exploding money supply, the imploding housing market, the subprime mortgage crisis, the slowing U.S. economy, and growing world political tensions – all have converged to make the dollar suddenly look very weak.
As you can see, the dollar has plummeted since our last update, passing its previous low of 82.47 on the dollar index chart. It's now poised to retest 80, the major bottom for the last 24 years. So you can place the dollars weakness into perspective, here is the chart we published last November tracking the dollar index since 1983.
In our opinion, the relative strength or weakness of the U.S. dollar is the key to unlocking the door to much higher precious metals prices, and that key may be now turning in the lock.
You don’t have to look very far to see the stark signs of a slowdown in the U.S. economy. Weakening GDP, durable goods orders, and ISM manufacturing and factory orders, along with rising unemployment claims and a tanking housing market, are all good reasons for the Fed to stimulate the economy with rate cuts sometime this year, or at least to hold rates flat. Still, while increasing liquidity might be an easy short-term solution for a slowdown, it could also be the final nail in the dollar's coffin.
At its simplest, the reason for the dollar's dismal immediate prospects maybe summed up in the deceptively benign phrase 'interest rate differential.' This is, of course, the difference between the cost of dollars and the cost of other currencies on the world market. Why is it important? Because it's the most obvious indication of how the world sees the dollar as an investment and whether foreign powers are likely to continue financing the astonishing $9 trillion U.S. public debt. What lies beneath the rate differential is the immense U.S. trade imbalance, which is rapidly becoming far more of an albatross for the U.S. economy than ever before.
In recent years, U.S. consumers have benefited immensely from a strong dollar policy known informally as Bretton-Woods II. The original Bretton-Woods agreement, as you probably know, was an international finance accord in 1944 that designated the U.S. dollar, backed by gold, as the reserve currency for global trade. It also stipulated that commodities like gold and oil be denominated in dollars internationally. A gold-backed dollar with fixed exchange rates was necessary at the time to ensure that war debts incurred by U.S. allies would be paid back in dollars without loss of value. In the 1950s, it was important for the U.S. to carry a trade deficit in order to rebuild the war-shattered international economy. Surpluses were returned to the U.S. in payment for war debts, not to buy U.S. Treasuries and other assets, as is currently the case.
Back to the Bretton-Woods
In Bretton-Woods II, informally in effect since 2001, Asian countries tie their currencies to the dollar at advantageous levels and use their reserves to lend money to the U.S. by purchasing its financial assets, especially Treasuries and other debt instruments. Thus, nations like China can pursue export-oriented economic strategies that maintain high growth and employment levels, and keep their currency cheap relative to the dollar. In return, the inflated dollar enables Americans to go on buying inexpensive imported goods, spend more than we save, and finance our enormous public and private debt at low interest rates from Asia.
In effect, this codependent relationship converts the U.S. payments imbalance into a debt-bubble in the U.S. economy. Holders of U.S. debt and assets, then, may see high returns provided by a juiced growth rate, as we've seen in recent years in the U.S. equities and housing markets. However, because this debt has been monetized by the Fed's easy money policies of printing ever more fiat currency, the rising asset prices provided by this artificial growth are denominated in money that's constantly losing purchasing power, creating a 'nothing for something' conundrum that undermines true wealth creation. (See Hard times for easy money.)
Of course, the wealth-effect experienced by holders of inflated assets makes them feel flush with cash, and thereby stimulates yet more consumption of inexpensive foreign goods. This process merely adds to the debt-bubble, which in turn becomes monetized once more in an accelerating cyclone of false wealth. The whole system has been justly described as the world's greatest vendor-financing scheme, in which nations like China and Japan simply lend us the money we need to keep buying their goods. More and more, like the old song goes, we owe our souls to the company store. And that store, increasingly, is owned and operated by China.
Predictably, the results are an unsustainable U.S. trade debt, an economy that's more beholden to foreign interests than ever before, and a dollar that is beginning looking like an Acapulco cliff diver about to execute a blasé swan dive into the rocks. In the fourth quarter, the U.S. current-account deficit, the broadest measure of our trade imbalance, amounted to 5.8% of GDP, down from 6.9% in the third quarter and a record 7% of GDP in the last three months of 2005. Yet from 1990 through 1997, it was never worse than 2%. The main problem with our trade gap, of course, is that our trading partners, who are lending us the money to finance our rampant consumption of imported goods, ultimately will expect to be repaid.
Because of Bretton-Woods II, more American assets than ever before are becoming the property of foreign powers. Led by Japan, China, and oil-exporting countries, foreign investors owned 44% of outstanding U.S. Treasuries at the end of 2006, 18% of U.S. agency bonds, 34% of U.S. corporate-debt securities, and 17% of U.S. equities, according to Bloomberg. A significant reduction of current imbalances (the U.S. deficit and correspondingly large Japanese, Chinese and German surpluses) would require a precipitous fall in the dollar and slower growth in the United States relative to the rest of the world.
So, to keep our debt afloat, the Fed must appeal to foreign holders and future buyers of our Treasuries by offering higher relative yields and a meaningful interest rate differential. However, the rate advantage the U.S. currently holds is expected to decline in 2007 as central banks in Europe and Japan raise rates. Sentiment toward the dollar on the currency exchanges is becoming very negative.
"They don't like the U.S. dollar anywhere and it is unanimously so," said Dennis Gartman of the Gartman Letter, last week. "Simply put, the market is now convinced that the future of the U.S. economy is one of relative weakness, while that of Europe is one of strength."
If the Fed decides to raise rates to maintain an advantageous rate-differential, the move would support the dollar temporarily but could deal a mortal blow to an already wounded housing market and a sputtering economy, which could, in turn, cripple the dollar in the longer term. On the other hand, if the Fed tries to stimulate the economy by cutting rates, it could precipitate an equally devastating crisis by reducing the interest rate differential that encourages foreign investors to hold dollars. If this happens, foreign holders of our dollar-denominated assets could easily abandon ship, leaving our stock and bond markets to sink along with the dollar.
Now we can see why the phrase 'interest rate differential' is so important for the dollar today. Given the enormity of our debts and deficits, and the undeniable fact of our economic slowdown, the dollar is perched on a cliff – one that registers right around 80 on the dollar index chart, the most important support level for the buck. Right now, the dollar looks like it wants to test that crucial support, and soon.
If the rate differential shifts against the dollar, little reason could be found for confidence in the currency. If the global adjustment to our trade imbalances were to be triggered by a sudden loss of confidence in the dollar, the result could be substantially higher U.S. inflation, a global recession, and a major financial crisis as rising loan defaults cause massive losses for banks. In other words, the dollar and U.S. economy would sink further into its own subprime swamp. And given the present signs of weakness in the U.S. economy, we're far more likely to see changes in the rate differential hurt the dollar than help it. Under these circumstances, gold, which is denominated in dollars, would climb right to the top of the charts.
China trade and the dollar
Trade relations with China are especially important because that country is not only the largest contributor to the exorbitant U.S. trade deficit but also the largest lender to the United States on an annual basis. Last year, when the U.S. Treasury debt increased by $184 billion, almost half of that amount — $87 billion — was provided by lenders in China, according to U.S. government statistics. What's more, China's currency reserves topped $1.2 trillion by the end of last month, according to Asia Times, confirming China's status as the world's biggest holder of foreign exchange reserves.
How China decides to use its newly acquired wealth has profound ramifications for financial and commodities markets worldwide, as evident in last year's jump in the gold price after reports that China was preparing to buy gold with some of its reserves. Many analysts fear China might decide suddenly to jettison its dollar holdings, setting off a tsunami of dollar-selling and damaging the U.S. economy. A Chinese decision to liquidate large amounts of Treasuries — or even to stop buying them — could indeed drive the dollar down sharply. So all of the recent economic saber-rattling over Chinese violations of intellectual property rights has a truly sobering subtext: China has the power to hobble our economy if it chooses, simply by deciding not to buy any more of our debt.
But that's not the only reason to worry about our addiction to Chinese goods. According to economist Henry C.K. Liu, the biggest danger for the dollar is not that China might sell U.S. Treasuries but rather that the U.S. sovereign debt rating is now dependent on the soundness of Chinese sovereign debt.
"If the Chinese economy hits a stone wall, as it will when the U.S. debt bubble bursts and Chinese export to the U.S. falls drastically, Chinese sovereign debt will lose credit rating, causing yuan interest rates to rise, causing more hot money to pour into China, causing Chinese central bankers to buy more U.S. Treasuries, forcing dollar interest rates to fall and more hot money to rush into China, turning the process into a financial tornado that will make the 1997 Asian financial crisis look like a harmless April shower." (See The US-China trade imbalance.)
As Liu explains, this scenario happened to Japan, but with foreign trade only 18% of GDP in 2003, Japan was able to keep the deflation within its borders. Still, the global economic impact was substantial. In China's case, where foreign trade runs around 80% of GDP, a financial crisis would spread quickly and the dollar would be hit hard.
The upshot is simply that the dollar has become so vulnerable from so many directions that it seems just a matter of time until the spam truly hits the fan. Our economic problems today are among the most challenging ever and won’t be solved quickly. We’ve gone from being the largest creditor nation to the largest debtor nation. We consume more oil than any other country, and we are more dependent on imported oil today than we were in the 1970s. Our currency is in a major decline, and the only reason it has not crashed further is there's no clear worldwide alternative—yet. Indeed, the dollar is fast becoming the old alpha male, barely leading the pack. Will the euro usurp its status as the world’s currency of choice, or will the yuan? Or will it be gold itself, as it was for so many centuries?
In any event, gold will benefit immensely from a global transition away from the dollar by becoming a repository for huge amounts of wealth as investors seek safe-haven alternatives. So once again, we urge you to take advantage of today's inexpensive gold market while you still can.
Recommended classic U.S. coins
These are the classic U.S. coins we recommend most highly today:
Power Pair #1 – An inexpensive pair of classic U.S. double eagles (a P-Mint $20 Saint-Gaudens in MS63 plus a pre-1900 $20 Liberty in MS62) at low premiums relative to gold bullion. Appropriate for conservative investors who like modest leverage to gold and complete financial privacy. Premiums on these classic gold coins are extremely low at the moment, making them a great, conservative buy right now.
U.S. $20 Liberty gold coins, MS64 – Our most popular investment coin. True scarcity, near-gem quality, and large gold content at low, low prices today!
U.S. 10 Indian gold coins, MS65 – Fantastic value! Combines extreme scarcity, gem quality, and very low premiums with huge upside potential.
U.S. Peace silver dollar rolls, BU – The smart way to buy silver. Inexpensive with excellent scarcity for the price.
And be sure to take a look at our superb inventory of classic U.S. gold coins. We’ve taken in some tax-related trades of classic U.S. gold coins recently and our current inventory has a great selection of much scarcer-than-average coins to choose from.
Please call 1-800-613-9323 and speak to one of our friendly rare coin experts if you see anything of interest or want to learn more.
That's it for now. As always, thanks for your time.
Dana Samuelson, President and Owner
Dr. Bill Musgrave, Vice President
AGE Gold Commentary
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