For those who have longed to live in financially interesting times, well, your time has arrived. Last weekend’s IMF-hosted G-20 finance minister pow-wow in Washington, D.C., failed to resolve much of anything other than the usual decision that more meetings are needed to solve the world’s ongoing currency wars. Following that display, it should be abundantly clear that it’s all over but the crying for the world’s fiat currencies. The post-Bretton Wood’s era of paper currencies, which officially began with Nixon’s closing of the gold window in 1971, is about to end badly. While nobody (except the clairvoyants among us) knows how or when the return to some form of gold standard will occur, there is an increasing likelihood that today’s age of fiat currencies will end with wild financial convulsions.
While many sources have done an excellent job covering the ongoing currency wars, I will briefly provide some background, cover some of the major developments and, more importantly, provide insight into how to protect your purchasing power and profit from the demise of the world’s largest experiment in fiat money.
To put the problems with the U.S. dollar (USD) into perspective, it is important to understand the make-up of the dollar index. According to our friends at Wikipedia, the U.S. Dollar Index (USDX) was first created in March 1973 shortly after the end of the Bretton Woods era and is a weighted geometric mean of the U.S. dollar compared to six major currencies. The composition of the USDX is as follows:
- Euro (EUR), 57.6%
- Pound sterling (GBP), 11.9% weight
- Canadian dollar (CAD), 9.1% weight
- Swedish krona (SEK), 4.2% weight and
- Swiss franc (CHF), 3.6% weight
- Japanese Yen (JPY), 13.6% weight
The U.S. dollar index, currently trading at a multi-month low of approximately $77, began trading in 1973 at $100 and was adjusted only once in 1999 when several European countries joined forces to create the euro. Most recently, the USDX is down 17 of the last 20 weeks and has lost approximately 12% of its value since trading at $88 in early June 2010.
Why is this important? The dollar weakness of the last several months tells us a great deal about the world’s perception of the U.S.’s green and white pieces of paper called Federal Reserve notes. I find it incredible that the USD has depreciated 12% in recent months against an index of currencies whose largest component is the euro. Think about it. It is truly shocking that the U.S. dollar continues to hit multi-month lows against a currency whose sponsoring countries are in the midst of a financial/banking crisis that may eventually dissolve the European Union. (For those keeping score at home, the dollar has sunk to $1.40 per euro)
Nearly as shocking is the USD reaching a 15-year low against the Japanese yen. The USD recently traded at ¥81.39 yen per USD, a level not seen since April 1995 (Source: Bloomberg). Given Japan’s heavy dependence on export-related industries, a strong yen may devastate the country’s economy. To mitigate the yen’s strength, Bank of Japan (BOJ) Governor Masaaki Shirakawa recently unveiled a new central bank weapon to the financial world: comprehensive monetary easing. Comprehensive monetary easing, which takes the place of Japan’s long standing program of quantitative easing, is a program whereby the BOJ will purchase $60 billion of rather toxic assets from banks and try to push its key overnight funds rate to between 0.0% and 0.1%, down from .1% (Source: Wall Street Journal). Additionally, Japan is rolling out a $422 billion stimulus program (announced in September 2010) in an attempt to jumpstart the country’s economic activity. After two lost decades of massive fiscal and monetary stimulus, one would think that today’s Japanese leaders would realize the futility of their recent actions.
Numerous central banks from Brazil to Switzerland have also taken steps in recent months to prevent their currencies from appreciating. They are finding out that they are no match for the sickly USD. The USD continues to trade lower regardless of the rhetoric or central bank interventions. Is there anything that can be done to stop the decline of the USD in the near future? Probably not in the short-term since there are simply too many dollars floating around due to the USD’s legacy as the world’s reserve currency. With an ongoing dishoarding of dollars, the USD is likely to suffer several nervous breakdowns in coming years before it finds a new equilibrium level. However, make no mistake, the USD will put in some confounding rallies on its way to the trash heap.
Gold is largely the mirror image of the USD. While there are numerous reasons gold continues to set record after record, none is more important than the world’s waning faith in colored pieces of paper. As I have discussed in numerous articles in this publication, gold is now becoming much more widely viewed as the alternative to the fiat currencies of our time. Gold has a number of things going for it that should keep its 10-year bull market intact for at least several more years. First, as central banks around the world continue to run their printing presses in an effort to keep their currencies from appreciating against the USD and support their export industries, more and more investors of every stripe and central banks will see the merits of owning gold. This pattern was confirmed by the World Gold Council who noted that central banks are expected to be net buyers of gold next year for the first time in nearly two decades:
“For next year, we will probably see a scenario where central banks are net buyers (of gold) for the first time in something like 17 years,”Marcus Grubb, the council’s M[anaging] D[irector] for investment, told delegates at the World Gold Investment Congress in London. He said central banks had been net buyers of 7.7 tons of gold in the second quarter of this year. Before last year, they were net sellers of an average of 400 tons a year. Source: Reuters, October 8, 2010
I believe the second reason gold will continue to rally is that the printing presses will not be turned off anytime soon due to the burgeoning deficits of many countries. Investment guru Jim Rodgers has been outspoken on this point for years:
“A huge amount is about not just U.S. deficits, but all deficits. Deficits are going berserk nearly everywhere. Throughout history, printing money has led to weaker currencies and higher prices for real assets.” Source: Businessweek, November 11, 2009
It is not just the U.S. federal debt that is out of control. Take for example where I live. The state of Illinois and the city of Chicago are the epitome of fiscal irresponsibility and should be the poster children for the gold bull market. The City of Chicago has fenced every asset possible, most recently the parking meters for the next 75 years, to continue its proliferate ways. Despite declining revenue in each of the last several years and few assets left to privatize, the City Council and Mayor are on the way to passing a budget where revenue will fall $650 million short of projected spending. The deficit is expected to be made up for by a one-time acceleration of the proceeds of previous asset sales and more borrowing. Shockingly, there is little discourse among the citizenry about a drastic re-structuring of city government. Good thing we have a former ballet-dancer (Rahm Emmanuel) running for Mayor to sort everything out. The State’s finances are even worse. Don’t just take my word for it. According to Bloomberg, Illinois credit default swaps (CDS) to insure the State’s debt reached a record 370 basis points in June 2010, higher than even CDS for the State of California. When, not if, Illinois defaults, any federal bailout will put severe pressure on the USD.
The third reason I believe gold will continue its progress is that it remains a small portion of current financial assets. While determining the exact percentage of financial assets that are invested in gold is a difficult matter, Ben Davies of Hinde Capital estimates that gold comprises only 1.5% of the world’s total financial assets and the supply of gold grows at only 2.5% per annum. [I would strongly suggest reading Mr. Davies numerous articles on gold and money which can be found at https://www.hindecapital.com/reports.] For gold to make up a meaningful portion of the world’s financial assets, a price of $5,000 per ounce can easily be envisioned.
With the USD wavering and gold’s acceptance and value gaining, it would not surprise me to see the gold clause return to contracts – particularly oil sale contracts involving Middle Eastern producers. While I am not aware of any plans for exporting countries to move away from the USD for pricing oil, the fall of the USD is certain to be sparking debate in OPEC countries to find ways to mitigate exposure the USD. Most exporting countries already have more U.S. dollars than they are probably comfortable holding. Pricing oil in gold, or at least including a gold clause in future sales contracts, mitigates a portion of OPEC’s USD problem. Expect rhetoric from OPEC to include calls for increased discipline in an effort to create a higher floor for the cartel’s product due to the continued fall of the USD.
Like gold and several other hard assets, oil has moved up in price in the past several months, but it has not kept up with several other commodities and remains well off of its high reached in 2008. On an inflation-adjusted basis, oil remains below the high achieved in 1980 despite the production of approximately 700 billion barrels in the past 30 years. Since hydrocarbons cannot be planted in the spring and harvested in the fall and cannot be created via a central bank printing press, energy assets are increasingly seen as stores of value.
With the end of USD hegemony in sight, what is one to do? I ask myself this question nearly everyday as I try to find the right mix of assets to protect my purchasing power and profit from the inevitable collapse of the USD. While gold, silver and the agricultural commodities have had significant moves recently; contrarian investors may want to consider investments in commodities that have not experienced such a significant appreciation in recent months. Oil and oil-weighted exploration and production (E&P) companies should outperform compared to most asset classes as investors re-discover the virtues of energy investing. I am still strongly of the opinion that natural gas and natural gas weighted equities provide the best values in the commodity world today. The fundamentals remain in place for higher natural gas prices. Production in the Gulf of Mexico, Texas, Wyoming, Oklahoma, New Mexico and Canada is falling and it is only a matter of time before declines from these areas force prices substantially higher.
Though the gold and silver rally has been very rewarding over the past couple of months, I plan to begin trimming my gold and silver equity exposure over the next six months. I plan to re-deploy the cash into my newsletter Model Portfolio energy related equities. While I am under no illusion that I will catch the intermediate top in the gold and silver equities, I am confident that I will be buying great oil and gas companies at great prices.
