The vexed question of the dollarOct 27, 2016·Alasdair Macleod
There is little doubt that the rapid expansion of both dollar-denominated debt and monetary quantities since the financial crisis will lead us into a currency crisis.
We just don’t know when, and the dollar is not alone. All the major paper currencies have been massively inflated in recent years. With the dollar acting as the world’s reserve currency, where the dollar goes, so do all the other fiat monies. Until that cataclysmic event, we watch currencies behave in increasingly unexpected, seemingly irrational ways. The fundamentals for Japan are not good, yet the yen remains the strongest currency of the big four. The Eurozone risks a systemic collapse, overwhelmed by political and financial headwinds, yet the euro’s exchange rate has proved relatively impervious to this deep uncertainty. The British economy is strongest, yet sterling is the weakest of the four majors.
If nothing else, today’s foreign exchanges are evidence that subjectivity triumphs over macroeconomic thinking. Mackay’s Extraordinary Popular Delusions and the Madness of Crowds beats computer modelling every time. Furthermore, any official attempt to establish a rate for the dollar has to address two separate questions: the value of the dollar relative to other currencies, and its purchasing power for goods and services.
The chart below indicates how the dollar has behaved against other currencies over the last five years, both on a trade weighted and on a predefined currency basis (DXY).
It should be noted that the dollar has risen on both these measures by roughly 18% since early 2014. At the same time, the Chinese yuan has fallen against the dollar by about 12%, so it has actually risen slightly against the DXY basket as a whole, particularly against the euro component, where it has gained 12% since early 2014. This matters, because far from devaluing, which is what we are routinely told by dollar-centric analysts, the yuan has been relatively stable over time against a basket of currencies. It has been weak against the dollar and yen, but strong against both the euro and sterling.
We should look at this from the Fed’s Federal Open Market Committee’s point of view. America runs a record trade deficit with China, and the only major economies where China’s terms of trade have improved are with the US, excepting Japan. Therefore, the Fed is bound to be very sensitive to the dollar’s exchange rate with China’s yuan Furthermore, on two occasions when the Fed had signalled it was going to raise the Fed Funds Rate, it backed off when the Chinese lowered the rate at which it had pegged the yuan to the dollar. Chinese devaluation against the dollar is obviously a prime concern for the Fed.
The situation becomes better understood when the Peoples Bank’s position is taken into account. The bank has been selling US Treasury stock in large quantities, stockpiling commodities and oil with the proceeds, though it has been diversifying into Japanese Government bonds as well. China’s dollars have been welcomed by markets, which are short of both quality collateral and raw currency. However, China’s supply of both has failed to stop the dollar rising against the yuan. Furthermore, China isn’t the only Asian and Middle Eastern state selling American paper, so the demand from other international players on the buy side has been immense, enough to determine the underlying direction of the dollar’s exchange rate.
The situation is being exploited by the Peoples Bank. In effect, the Peoples Bank is in a position to dictate Fed policy by adjusting the rate at which it is prepared to supply dollars into the market. So long as the dollar remains fundamentally strong, it only has to slow the pace of Treasury and dollar sales for the dollar to rise, and therefore the Fed’s planned interest rate rises to be deferred. This is not understood properly by western commentators, who erroneously think China is being forced to defend a declining yuan. Nothing could be further from the truth. It will be interesting to see whether this happens again ahead of the December FOMC meeting, when for the umpteenth time we have been promised a rise in the Fed Funds Rate.
A major consideration behind China’s foreign exchange policy is the outlook for the euro. The Eurozone represents a market as large as the US, with the added importance of being tagged onto the Asian continent. There can be little doubt that China sees her own long-term future being aligned more with Europe than America, despite Europe’s current troubles. It is, if you like, a situation that is primarily of strategic importance. Europe’s economy will need rescuing at some stage, and is therefore a future opportunity for China’s intervention.
That plan is for the long term, and becomes increasingly valid the deeper the hole the Eurozone digs for itself. A disintegration of the EU would also be beneficial for Chinese ambitions. Meanwhile, in the short-term the euro has broken a crucial trend-line against the dollar, having completed a continuation head-and-shoulders pattern, targeting the 1.0600 area, which is the previous low seen in March and November 2015. This is our second chart.
Neither the Peoples Bank nor the Fed need to be chart experts to see what’s happening. Brexit was very bad news for the euro, because it is a racing certainty that the event will turn out to be just the start of a new round of political and economic trouble for the Eurozone. The Italian economy in particular is imploding, with a non-performing loan problem that is roughly 40% of private sector GDP.
So China can for the moment steer a course for the yuan between the euro’s devaluation and the dollar’s rise. The Fed sees in euro weakness an increase of currency-induced deflation for the US economy, and a loss of competitiveness for US exports. Chinese exporters are obvious beneficiaries as well, so the blame for deflation will be on China’s foreign exchange machinations.
Anyway, China probably cares less than she ever did about the long-term consequences of her actions on the US economy. China has been selling her US Treasuries and reducing her dollar exposure to add to her stockpiles of raw materials and oil. She wants to keep her over-indebted businesses trading by maintaining a favourable exchange rate with the dollar, particularly given the developing train wreck that’s the Eurozone. And there’s not a lot the Fed can do about it.
Gold and commodities
The principal driver for the gold price is the prospect of monetary inflation transmuting into price inflation, and the inability of central banks to respond to this threat by raising interest rates sufficiently to control the balance of consumer preferences between goods and holding money.
We are, of course, measuring gold in dollars, because the latter is the reserve currency for all the others. But, as stated above, there are two exchange considerations, the first being the dollar against other currencies, and the second the dollar against a basket of commodities. And here, we should note that over the long-term, the prices of commodities measured in gold are considerably more stable than the prices of commodities measured in fiat currencies.
China has behaved as if she is thoroughly aware of gold’s pricing attributes, and has a deliberate policy of dominating the market for bullion. This is very different from the US’s domination of gold paper markets. Not only has China invested in unprofitable gold mines to become the largest producer at about 450 tonnes annually, but the state monopolises China’s refining capacity. She also imports doré for refining from other countries, and without doubt since 1983 has accumulated substantial quantities of bullion not included in monetary reserves. Furthermore, it is the only country that has encouraged its population, through television and other media, to accumulate physical gold. Make no mistake, for the last thirty-three years, the Chinese government has made a credible attempt to gain ultimate control over the physical gold market, and to extend gold’s protection to her own citizens.
China does not manipulate the gold price. Instead, as described earlier, she is manipulating the dollar by regulating the exchange rate and by discouraging the Fed from raising interest rates. It is a temporary balancing act that only continues so long as desperate banks and their indebted borrowers continue to scramble for dollars, and China knows it. The Fed, for the moment, appears to be powerless to manage economic outcomes and is firmly trapped by China’s currency management, with interest rates stuck at the lower bound. And to make it worse, the weak euro, against which the dollar index (DXY) is very heavily weighted (57%!), threatens to force the DXY index even higher. The result, inevitably, is that monetary policy cannot be used to address future price inflation, which virtually guarantees there will be a higher gold price in 2017 and beyond.
This is why, despite American wishful thinking, gold remains at the centre of the financial system. It is central partly because China’s ensures it is, and it is also China’s ultimate money for commodity and trade purposes.
China most likely has enough gold to fully compensate for her reserve losses from the destruction of the dollar and the other fiat currencies on her reserve book. She is deliberately selling down her dollar exposure anyway, while she can. Lest we forget, communist economists in China were taught that capitalism destroys itself. For them, there is no clearer proof than the performance of the US economy and the dollar, and they do not intend to get caught up in its demise. Understand this, and you understand all.
While the monetary role of gold in the future has yet to be determined by China, and it will be China or the markets that make the decision, for the moment it can be regarded as the ultimate insurance against global currency failure.
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