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Gold is an Attractive Buy Again …Thanks to a Strong U.S. Dollar
If you only read the U.S. press, you would think that gold is falling into the tank, down from $1300 in July to $1225 in mid-September. But if you live in Europe, you would see a gently rising gold price, denominated in a currency that is collapsing due to the threat of deflation and recession in the Euro-zone.
The euro started 2014 at around $1.40 to the dollar. At the start of 2014, gold was $1201 per ounce in U.S. dollars, so an equivalent ounce of gold cost 858 euros on January 1, 2014 (that’s $1201 divided by $1.40). In early September, the euro slid to $1.29 and gold fell to a low of $1225 in U.S. dollar terms, so the cost of an ounce of gold is now around 950 euros. So far in 2014, gold is up 2% in dollar terms and up over 10% in euro terms. That means Europeans are pleased with gold’s relative performance in 2014.
As we have said all along, gold is an alternative currency choice. Gold does not compete with stocks for your investment dollar. It competes with dollars, euros, yen, British pounds, Russian rubles, a variety of Latin American pesos and the ascendant Chinese yuan. Gold is difficult and expensive to find and mine, but running a printing press overtime or adding another zero to a debased paper currency costs very little.
The dollar is temporarily high because it is a haven of safety from weaker currencies in the war zones of Eastern Europe and the Middle East. The dollar is particularly strong against the euro, its major global competitor, since the European Central Bank (ECB) has just lowered its key short-term repurchase rate from 0.15% to 0.05%. The ECB is also charging member banks 0.2% for any overnight euro deposits.
Europe is desperately fighting deflation, and gold has always performed relatively well during times of deflation. The United States endured a long slow deflation from 1878 to 1900, but that was a time of great industrial expansion under the gold standard, when both gold and silver held their value while prices declined. (In a deflation, a flat price is a “real” gain.) The U.S. also suffered a sharp deflation in the 1930s. In 1934, gold was revalued from $20.67 to $35.00 per ounce while other prices were falling. (In the 1930s, the only stocks that gained 100% or 200% or more were in the domestic gold mining sector!)
Now, we’re seeing deflation in Europe. Prices are already declining in Italy and Spain, with the overall Euro-zone consumer price index close to zero. Gold is rising in euro terms due in large part to the threat of deflation in the Euro-zone. The question is: Why should U.S. investors care? If U.S. investors buy gold in U.S. dollar terms, aren’t we hoping for a weaker dollar to help the gold price to increase again?
Rest Assured – the U.S. Dollar Will Fall Again!
The U.S. dollar is unusually strong right now because the U.S. Federal Reserve is almost through winding down its two0year siege of QE-3 (the third round of quantitative easing). At the same time, the ECB is deliberately weakening the euro. When global investors look at their currency choices now, they see 10-year German euro-bonds (“bunds”) yielding just 0.9%, while the 10-year U.S. Treasury note yields 2.6%, so currency and bond investors naturally will sell euros and buy dollars, pushing the dollar even higher.
The dollar will likely continue to rise, short-term, simply because global investors seek higher real yields. Longer-term, however, the dollar will fall again, since the Federal Reserve will remain very reluctant to raise short-term interest rates from their currently ultra-low levels (officially, the Fed funds rate is a range of zero to 0.25%, but in practical terms the short-term return has been under 0.1%, similar to the euro.)
It’s an old, old story. Most central banks, given a choice, will continue to print more money and keep short-term interest rates ultra-low to prevent severe recessions and to forestall the pain of facing higher interest charges on their runaway government debts. The U.S. federal debt is currently over $17 trillion, so an increase of just 1% in the average Treasury rate will deepen the annual deficit by over $170 billion.
At the same time, many central banks are continuing to buy gold at near-record annual rates. The Russian ruble, for instance, is collapsing, but Vladimir Putin and his central bank are buying massive amounts of gold to shore up that nation’s foreign exchange coffers during times of economic sanctions and currency erosion. How ironic that global leaders are buying tons of gold even while they debase their currencies.
With the emergence of China as a superpower (and Russia emerging as a newly belligerent superpower), the Chinese yuan is gaining favor in many major currency markets and in trade treaties. At the end of this month, the Shanghai Gold Exchange will open to global traders. They are planning to trade gold contracts exclusively in the Chinese yuan. Also, China recently signed a 150 billion yuan (worth about $24 billion) currency swap agreement with the Swiss central bank in order to facilitate trade between the two nations.
In another move away from the dollar, Russia announced last month that Gazprom, Russia’s huge oil conglomerate, will only accept Russian rubles and Chinese yuan for their oil deliveries. This is all part of the trade war (sanctions and counter-sanctions) between Russia and the West. There are usually no winners in such trade wars – except those who buy gold as a “neutral” currency in any such trade war.
Gold is also the Ultimate “Insurance Policy” Against ISIS Forces
As the war against ISIS in the Middle East escalates, it’s likely that many of the super-rich investors in that region will first turn to the dollar in their “flight to safety,” but they will almost certainly add gold to their investment portfolio as their ultimate escape currency. Most of the rest of the world honors gold’s historical role as a currency of last resort. In America, we face no such imminent threat to life and limb, but if ISIS did manage to fulfill their promise of attacking on American soil, gold might begin to escalate in another long-term bull market, as it did after 9-11, growing 7-fold in the decade from 2001 to 2011.
On September 10, 2001, gold was mired around $271 per ounce after suffering nearly 20 years of flat or declining prices. But the impact of the 9-11 Attack on America launched gold on a long-term (10-year) bull market that was more solid (gradual) than the sharp price rise of the late 1970s (rising from $103 to $850 in 3+ years). On September 5, 2011 – one week short of a decade following 9-11 – gold peaked at an intra-day high of $1922 and a London closing high of $1895 per ounce, a 7-fold increase in 10 years.
We’re not anticipating another 10-year 600% increase in gold prices, but gold will almost certainly retain its role as a crisis hedge against any future escalation of hostilities in the Middle East or Ukraine. Gold has tended to rise or fall this year in parallel with the level of tensions in Russia and the Ukraine. That conflict may be on the back burner right now, but we certainly haven’t seen the last of Putin’s ambitions.
At times like this, gold is a financial portfolio insurance policy that nobody wants to cash in. The role of insurance is to provide peace of mind in relatively good times by providing protection against bad times.
Like life insurance, your gold insurance policy does not represent more than a small percentage of your total net worth, but you hope to pay regular insurance premiums and not cash in your policy prematurely.