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Thursday September 30, 2010 - 01:48:15 GMT
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Don't Look for US to Stand in Way of Weaker Dollar

While we have yet to see any member of the Obama administration including a senior Treasury official protest currency intervention by Japan to weaken the yen (buying dollars), we are confident that the US is not in the least concerned about the sliding USD.  If anything, officials must be applauding the orderly decline to date and would like nothing more than to see a major weakening in the USD versus CNY ahead, which if it were to happen would surely mean more declines in the dollar against most currencies. 


Indeed core inflation fell to 1.0% in August from 1.2% in July all the while the dollar was declining.  If the weaker dollar leads to some inflation then all the better.  The premise for more Fed QE ahead is built around getting core inflation back up to 2.0%, the “target”.  So the notion from the Fed’s point of view that a sliding dollar is inflationary and to be avoided is incorrect. 


And it is equally clear at US Treasury, which is titular director of US currency policy, that the slide in the dollar since July has done little to undermine US Treasuries (yields are near record lows and the curve is flat).  In other words there is no sign of dollar weakness undermining confidence in the US debt market…just look at this week’s Treasury auctions for a read on the linkage between a weak dollar and demand for Treasuries.  Indeed if anything, foreign official demand for Treasuries rises during periods of dollar weakness, as it implies greater USD accumulation via intervention policies in the developing world (and now add Japan to the interventionists). 


Some point to record (nominal) gold prices and say that is a reflection of where markets see the dollar going (all fiat currencies some argue).  But I think one would be hard pressed to find any government on the planet that is ready to embrace gold as an alternative to sound economic policy for the backing of a currency.  I suspect what is happening here is not the world’s investors betting on a Zimbabwe outcome for the USA ahead – debt spiral and collapsing currency.  Frankly anyone with this view has to be betting on not just a black swan event but a pink polka dotted swan event.  What is happening in gold is a massive correlation trade and many investors wanting to add gold to complete a more diversified portfolio.  On top of that there are piles of speculators long gold and we know that they are not gold bugs and will sell at the first sign of pain (probably when the USD bounces…US economy starts to find a foothold in 2011).  So foobar on signals about the lifespan of the buck in gold prices and again I think this view is shared in every capital on the planet.  Buffett reportedly said this week that the current value of all the gold mined since the beginning of time would buy half of all residential real estate in the US.  In terms of supply, all mined gold (unmined stock is not great) can fit in a few Olympic sized swimming pools.  Frankly it seems wildly pessimistic on the future to believe gold has no downside risk and for what additional upside reward?  Full disclosure my gold position is limited to my wedding band and a crown when enamel crowns were more expensive. 


So I could not help but notice that US Undersecretary of the Treasury Brainard today was asked about foreign exchange policy in China and said issues associated with global rebalancing will be discussed at the upcoming G20 meeting (October 08-09) in South Korea.  It would follow that Japan’s recent efforts to weaken the yen (and strengthen the dollar) run counter to the rebalancing process, not to mention blur the argument somewhat for China to allow its currency to appreciate (stop intervening so much).  For those who worry that if China allows the yuan to rise it will buy far fewer dollars and hence US Treasuries and US rates will rise.  Well not when the US savings rate is the highest in decades and many households are reluctant to buy stocks and are buying government debt in an unprecedented fashion.  Moreover, not when the Fed is ready to start an open-ended government debt purchase program (markets should think less about the speed or flow of Fed Treasury purchases as we now know they are likely to be modest and gradual, and should think more about the stock or quantity of Treasury purchases over time – unspecified we are told and if inflation stays low and unemployment high, we could see this program carry on for several years resulting in a much larger balance sheet…for the Fed it is the stock not the flow of purchases that matters).


With the USD increasingly untethered, and with official US implied blessing (silence speaks volumes), the downside is pretty wide open and does not carry the risk of a long gold position IMHO.  When does the dollar decline trough?  Only when the US economy gathers speed and markets begin to price in an exit strategy for Fed unconventional policy…at the very earliest that will be somewhere in mid-2011 we think.  Meanwhile ECB officials (Stark and Mersch) indicated Tuesday that the ECB may end unconventional policy at year-end.    And just look at EURUSD near 1.36 (and near April high before EZ periphery story exploded) with the Irish and Portuguese gifts that keep on giving…QE2 trumps PIIGs.


David Gilmore

860 676 9102


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