Gold, the Dollar, and the G-7

February 24, 1997 – The finance ministers of the G-7 industrialized nations have spoken. ‘The Dollar stops here!’

After two years of Dollar strength relative to the other major national currencies, we are entering a new era. No more Dollar strength. No more Yen and Deutschemark weakness. So they say. We’ll see.

I question whether the G-7 finance ministers can pull off what I think may actually require a minor miracle. They expect to keep the Dollar at current levels. In other words, instead of rising or falling against the other major currencies, the finance ministers expect the Dollar to remain more or less at current rates of exchange. I doubt it.

First there are the economic issues. While the German and Japanese economies have been weak, they will not remain weak forever. Any recovery in their economies will undoubtedly strengthen their currencies, just like any serious and prolonged weakness in the US economy – which inevitably and eventually will come once again – will hurt the Dollar.

Then there are the market related issues. In a world of freely floating exchange rates, it is unreasonable to expect these rates to remain relatively unchanged. It just doesn’t happen. There are too many factors causing currencies to fluctuate. There is too much money circling the globe looking for a safe and secure home. Consequently, I doubt whether the US Dollar will stand still, and if the G-7 ministers are sincere in not wanting it to go higher – and I think they are believable – then the Dollar will once again start heading south.

Economics dictate this outcome for the Dollar. So does common sense. The Dollar has been on a downhill ride against the other major currencies for more than thirty years, and nothing has fundamentally changed for the Dollar. The federal government is still spending and borrowing itself into oblivion, a process which is taking the Dollar along with it. To suggest any outcome other than a continuing, prolonged decline in the Dollar against the other major national currencies flies in the face of logic and common sense.

There are of course periodic bear market rallies in the Dollar, like the one we have recently been witnessing. But eventually the Dollar’s rate of exchange always falls to yet another new low. It is in the end simply a matter of supply and demand.

The United States is flooding the world with Dollars. First, there are the trade imbalances, which puts about $200 billion in the hands of overseas individuals and companies every year. Then there are the capital flows. The federal government budget deficit has largely been financed by overseas money the last couple of years, so we’re talking about another $300 billion or so from these sources.

In short there are a lot of Dollars sloshing around the system. As the largest debtor on the planet – and as one wag recently put it, probably the largest debtor in the universe – the United States now owes the rest of the world more than $1 trillion. But what about demand? What is the incentive for overseas investors to continue holding this enormous amount of IOU’s denominated in Dollars?

When the Dollar was rising, the incentive was clear. A rising Dollar provided a nice gain for these investors against their depreciating national currency. But the G-7 has announced that this incentive is now disappearing. Therefore, the only motivation to remain with the Dollar comes from interest rate differentials – US interest rates are slightly higher than those of most other currencies. However, interest rates are higher in the United States for a reason.

There are greater risks in holding the Dollar than most other currencies. The risk of inflation is greater; the risk of default by the federal government is greater; and presently, the risk of a fall in the exchange rate of the Dollar is greater.

Are Dollar interest rates high enough to offset these higher risks? In my book, they aren’t, and if overseas investors who now hold all these Dollars that have flooded the world begin making the same conclusion, then expect the Dollar to fall.

I think the outlook for the Dollar is bleak, and the G-7 finance ministers may have unleashed a tidal wave. Importantly, this wave will also impact Gold.

Look at the world from the point of view of a German or Japanese investor, but the logic really holds for anyone outside of the United States. Your domestic economy is doing poorly, offering little incentive to invest capital. You therefore want to protect this capital safely and earn a fair return until you can bring it back home. Or alternatively, the capital may be part of a nest-egg that you want to invest safely and securely without undue risk in order to obtain prudent diversification in your portfolio. In either case, in the new environment after the G-7 announcement, there no longer is any incentive to hold the Dollar.

It is clear that the big gain that we have seen over the past two years in the Dollar’s exchange rate is finished. Therefore, it’s time for the overseas holders of Dollars to move on to something else. And as this money comes out of the Dollar, it is inevitable that some of it will flow into Gold.

Over the past several months, the Dollar has surged, and Gold got hit pretty hard. Now those trends are about to reverse. The Dollar’s strength is finished, so says the G-7 finance ministers. Left unsaid by them was that the Gold price will rise, but the market spoke instead.

Gold has jumped more than 5% above its low only two short weeks ago. Look for more of the same in the weeks and months ahead.