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September 29, 2000

The US Dollar: Over Owned and Over Valued
by John Hathaway

I invest in gold shares for a living. I manage a gold sector mutual fund. Despite this, I do not long for a return to the gold standard or wish to prescribe any particular solution for this or that economic ill. I am not as captivated as some by geological speculations. The finer points of mine engineering or nifty metallurgical nuances disinterest me unless they pertain directly to value creation in our portfolios. The painstaking bean counting necessary to construct supply and demand models for the gold market does not dazzle me. The promotion of gold as jewelry and the liberalization of Asian retail markets are constructive, I suppose, but in the final analysis do little to form a rationale for investing in the sector. Finally, I am not caught up in conspiracy theories. None of the foregoing considerations, it seems to me, add up to a money making proposition.

Why then, you must be asking, would I be doing this? I see gold as a way to reap a tidy profit on impending changes in the financial landscape. It is a speculation against financial assets, against the preeminence of the US Dollar, and against the financial market speculation that has raised dollar to its untenable, almighty stature.

I am only interested because of the possibility that gold might, within a reasonable time frame, i.e., in my lifetime, trade at $500 or even $5000/ounce. A breakout, to say $325, which we would all enjoy, would be hardly worth the expenditure, the investment, or the time it has taken for such a paltry result. Gold is a potentially huge score. What keeps me interested in this wasteland barren of investment returns are the positive macro economic trends for gold. There are encouraging signs that the high water mark has passed for the dollar, financial assets, and the credit boom that has fueled the bull market in paper and the bear market in gold.

Hedging, Derivatives, The Short Interest, and Conspiracy

For the most part, these considerations are ancillary to the main thrust of my investment reasoning. However, it is worth spending a minute or two to the extent that they can shed light on the structure of the gold market. At best, these factors will lead to periodic short covering rallies. By themselves, their existence will not attract speculative capital to this arena.

The existence of a large and vulnerable target in the form of an outsized short interest will help propel the gold price once the dollar is under attack. Conspiracy, in my opinion, is too strong a word for what is going on in the gold market. However, it should surprise no one that some form of manipulation is taking place. Governments routinely intervene in the currency markets. Gold is a form of currency. As stated by Professor Robert Mundell, Nobel Price Winner, "gold is subject to a lot of elements of instability, not the least of which is the attempt on the part of several big governments to make it unstable." Mundell made these comments at the World Gold Council's 1999 Fall Symposium in Paris, at which he was the honored guest.

Since World War II, various governments, and especially the United States, have steadily moved in the direction of marginalizing gold as a reserve asset. At different points in time, these efforts have been coordinated among several governments, although the motivations among the various participants have not always been consonant. The first notable example of such activity was the London Gold Pool, a joint effort by the United States and several European governments to depress the free market price of gold to disguise the growing weakness of the US dollar. This effort lasted over a decade, from the mid 1950's to 1968. At no time during the pool's operations was there any advance official acknowledgement that such operations were being conducted. Market players were kept in the dark. However, speculators were able to infer the pool's existence from the price behavior of gold, figures on US gold reserve assets, and the balance of payments. As a result of the pool’s activities, substantial economic interests arose which would win or lose depending on its success in depressing the gold price. As time passed, the incentives of all participants to keep the free market price of gold at $35/oz diverged, most notably France. Once national economic interests diverged, increasing flows of speculative capital mobilized and ultimately defeated the government scheme. Fortunes were made at the expense of taxpayers, especially US taxpayers.

Since the early days of the Clinton administration, the tradition of manipulating the free market gold price has been honored. As with the gold pool, the actual origins are probably obscure. While far more complex, current Anglo-American led efforts to depress the price have one very important similarity to the gold pool. The financial stakes of public and private market participants are huge. These interests extend well beyond the immediate gold market.

There is no better illustration than the panic in government and private circles that was touched off by the Washington Agreement. Central bank officials appeared to be clueless as to the structure of the gold market, especially as to the size and location of the short position that had been required to keep the gold price locked in a downtrend. They were horrified by the volatility of the gold price in the following days, and of the potential damage to bullion dealers, many of whom were also major international banks (see "JP Morgan To The Rescue?" for more detail). The crisis galvanized the central banking community into quick action to provide liquidity for the gold market, which was about to vaporize. The provision of liquidity in the moment of crisis emboldened dealers to expand positions. As noted by Reginald Howe (The Golden Sextant), the mysterious Exchange Stabilization Fund, managed by the US Treasury, lost $1.6 billion during the 4th calendar quarter, more than it earned in all of 1999. After this near death experience, it is likely the official sector's resolve to keep gold in the deep freeze was reinforced. The continuing expansion of dealer derivative positions despite declining producer hedging, and especially the lengthening of maturities reported in the BIS and OCC numbers, suggest renewed conviction among dealers that divine assistance will never be too far away in time or price.

At the same time, the Washington Agreement marks a watershed for the gold market. Even though central bankers worked together to end the crisis, the interests of the Europeans and the Anglo/American camps with respect to gold may have started to diverge. This is despite the fact that Europeans bankers continue to be persuaded by bullion dealers into "active" management of their gold reserves, (i.e., leasing and dispositions to invest in interest bearing securities including, Euro denominated.) It is also despite the fact the US and Britain were signatories to the agreement, an act they may have found distasteful. The Agreement marks the first step towards the reinstatement of gold as a monetary reserve asset. If the Euro continues to have problems, the Europeans will figure out that there is little advantage to trashing their largest reserve asset other than dollars. Professor Mundell has suggested that the European Central Banks issue gold coins as part of this current intervention: "The production of a gold currency would heighten general interest in the euro and at the same time put the EU’s excess gold reserves to good use."

At the end of the day, these structural considerations are interesting for two reasons. First, they are necessary to understand what has already transpired in the gold market. More important, they shed light on the massive misallocation of investment capital. The continued existence of a large short interest, which is impossible to cover other than from longer term deliveries from new mine production or official sector sales, increases the potential upside move in gold.

The Clinton Dollar

The case for renewed investment interest in gold centers on the proposition that the US dollar is at or near its peak. Should this be the case, investment flows will seek out alternatives, including gold. The dollar is the unrivaled instrument of international credit and capital flows. It is the foundation for most commercial and financial market transactions. The perception that the dollar is a store of value as well as a medium of exchange explains the willingness of governments, businesses and individuals worldwide to hold dollar instruments to the near exclusion of alternatives. However, it was not always so.

During the early 1960's, 1970's and 1980's, the US dollar was suspect. In the 1960's, the most obvious flaw was a deteriorating balance of payments position. Other indicators such as inflation, interest rates, and equity markets were favorable or benign. The geopolitical situation, however, was dicey. It was not entirely clear that capitalism and the US would ultimately prevail over the competing forces of communism and the Soviet bloc. The gold pool attempted to disguise the dollar's chronic weakness by depressing the free market price of gold.

In complete contrast, the Clinton/Rubin/Summers dollar is beyond reproach and is almost universally admired. At the recent Financial Times gold conference in June, central bankers openly worried about the future of gold, but never voiced concern as to their potentially imprudent concentration in US dollars. The possibility that US budget surpluses would shrink the supply of government debt was openly mourned, despite the fact that OMB projections show no such shrinkage. These projections, found on the OMB web site, show government debt increasing in every year through 2012, as far out as the projections go. Still, the rage among these seemingly ill informed central bankers is a pronounced preference for interest earning paper assets to stagnant bars of bullion. And the preferred paper asset by far is the US Dollar, which represents 77.7% of world central bank reserves, according to the latest BIS annual report. The percentage is certainly disproportionate to the US share of world trade and economic activity.

The US trade deficit will reach 4.3% of GDP this year, as noted in a paper (Perspectives on OECD Economic Integration: Implications for US Current Account Adjustment) presented to world central bankers at the annual Jackson Hole symposium by Professors Obstfeld and Rogoff. More important is the percentage of US financial assets held abroad, $1.9 trillion or nearly 20% on a net basis of GDP, the highest since the 1800's. They argue that only a small percentage of GDP is "tradable", the remainder being explained by non-tradable components of GDP such as rent, transportation, labor etc. The percentage of GDP that is internationally traded, or readily redeemable for dollars held abroad, may only be 20% to 25% of the total, suggesting a higher rate of borrowing and a lower degree of national solvency than is generally perceived. According to the professors, "a critical issue in determining sustainability is not simply the rate of borrowing, but accumulated debt." They assess the risks of a dollar crash as significant. While not predicting such an outcome, the study suggests that a sudden depreciation of 24%-40% could occur if foreigners moved quickly to exchange their dollars.

The disproportionate ownership of the dollar is widespread throughout numerous asset classes. According to Bridgewater Daily Observations, gross foreign ownership of US assets now measures over $6.4 trillion (66% of GDP). Foreigners own a record 38% of the US treasury market, and 44% excluding Federal Reserve holdings. They own a record 20% of the US corporate bond market and 8% of the US equity market. What would a change of sentiment on the dollar do to US asset prices?

Keep in mind that the dollar's strength is only relative to the Euro and the Yen, two seemingly unappealing alternatives. Neither has been regarded as a serious rival, with their shortcomings widely publicized. The integration of world financial markets has eliminated many of the traditional safe havens such as the d-mark or the Swiss franc. World capital flows dwarf even the more liquid currencies. It seems as if it has come down to the dollar or nothing at all. Nothing at all, except for gold, which stands to become the protest vote on the monetary ballot, the equivalent of "none of the above."

The epic strength of the dollar is no longer something to celebrate. The weakness of the Euro in particular has created sufficient discomfort to trigger a round of concerted multinational intervention. The interdependence of world economies and financial markets means that the dollar cannot be isolated or insulated. Whenever the foreign exchange markets force the hand of central bankers, there is reason for us to cheer. Interventions rarely work in the long term. Perhaps the Euro will be viable, but there is no precedent for a successful multinational currency. It was the prospect of the Euro in large part that led European central bankers to view their reserve assets, especially gold, as redundant.

It is possible that the Euro will turn out to be a fiasco, notwithstanding the current rescue effort. Even though the economic fundamentals of Europe are improving, that does not assure success for this experimental, peculiar currency. The ECB is issuing Euros at growth rate of 10% on a 12 month basis and nearly 20% in recent months. Banana republic growth rates may help explain the market's aversion. An eventual abandonment of the Euro would be bullish for gold and possibly bearish for the dollar, but the demise of the Euro is not the only potential source of renewed investment interest for the metal. Time and space will not permit me than to do more than merely mention some others:

• banking derivatives. The potential miscalculations in the gold market are minuscule compared to the bets that have been placed on the foreign exchange and interest rate markets. According to the BIS, total derivatives on interest rates and currencies measure in the hundreds of trillions.
• under investment in the commodity sector will lead to shortages and spiraling prices in certain commodities. What is happening in oil is a template for nearly all other basic resources. A softening economy, favored by the bond vigilantes, will only starve the resource sector of the necessary capital investment to meet growing demand. The rise in commodity prices over the past year is not a fluke.
• excessive investment in the high tech and telecommunications sectors will lead to banking and bad loan problems reminiscent of tanker loans, S&L defaults, real estate, and other similar misadventures.
• the doctrine of just in time inventory management has resulted in a run down of critical stocks of basic materials. Supply shocks will evoke consumer responses similar to that recently witnessed in Europe during the protests over high energy prices. If the markets lose their confidence in deliverability, there could be a secular swing towards restocking and hoarding.
• the over concentration in US financial assets. Recent acquisitions of behemoth financial institutions by their foreign counterparts are another sign of a market peak for financial assets.
• a recession would undoubtedly trigger renewed monetary ease, including lower interest rates and more rapid money growth.
• US equity prices seem to have peaked out, with no new highs in the DJII, S&P, and NASDAQ Composite since the first quarter of this year. Most stocks peaked out a year or more before the averages.
• a bear market or a recession would depress tax revenues and undermine the outlook for a budget surplus.

The dollar is potentially vulnerable on these and many other fronts. It is vulnerable, because like an overvalued growth stock, it is priced for perfection. It is vulnerable, because like an overvalued growth stock, it is over owned. The inflation news cannot remain rosy forever. The BLS reports on the CPI and PPI are already viewed with suspicion. The concept of a core inflation rate has become laughable. The idea that inflationary threats can be stifled by high interest rates, restrictive money growth, and tight fiscal policies seems questionable against today's political and even geopolitical realities. The productivity myth rests on the dubious foundation of hedonic pricing methods, a methodology applied to the BLS price indices at the beginning of the Clinton administration. Even the Deutsche Bundesbank and OECD have recently challenged the validity of this centerpiece of financial market lore. Using this methodology, the BLS has inflated spending of $28 billion by business on computer hardware, or 3% of nominal GDP growth, to $127 billion or 20% (Richebacher Letter-Sept.2000) The impact of these adjustments is a substantial overstatement of productivity figures and an understatement of consumer price inflation.

The policies and practices of the Clinton Administration's Treasury department have established the dollar as the premier currency. This exceptional high standing is essential to the low inflation rate enjoyed in the US but not in the rest of the world. A weaker dollar would hinder the access of the American consumer to cheap foreign items and therefore lead to higher inflation.

The dollar is high because of a successful and widespread campaign across a number of fronts and the confluence of external events that included:

• implementation of hedonic pricing methodology to BLS statistics.
• widespread financial market reforms that encouraged banking industry consolidation and the emergence of financial institutions of unprecedented scale.
• removal of trade barriers -curtailment of longer term treasury debt maturities
• endless spin on a strong dollar -making sure gold did not establish an uptrend.
• the demise of the Soviet empire.
• the strong fiscal position of the US.

There were probably a number of other contributors to this strong dollar policy. These developments interacted with the markets in a way that reinforced the dollar's strength and undermined gold. However these measures and/or events, like the Clinton administration, will soon be history. The explanations are similar to those associated with great growth stocks at their peak valuations. They are easy to articulate in retrospect, and there is a tendency by market participants to extrapolate more of the same. However, we may have reached the limits of the desirability of a strong dollar based on the extreme position of our trade balance and foreign asset ownership. The Euro intervention is a tip off that there is sufficient disquiet in the public and private sector that a change is in the wind.

The real clues to the outlook for gold lie in the market for the US dollar. The Clinton administration's strong dollar campaign has enjoyed wild success, creating an insatiable appetite for the paper. This success is a principal reason for the dollar's present vulnerability. When will foreign holders of US assets begin to suffer from buyers' remorse and realize that the strong dollar has gone too far? The fundamentals supporting a change of opinion have been in place for some time and without a catalyst could continue. Identifying a particular catalyst is very tricky, but there seems little doubt that prospects for a change of direction are promising.

John Hathaway
© Tocqueville Asset Management L.P.

This commentary is not an advertisement or solicitation to subscribe to The Tocqueville Gold Fund, which may only be made by prospectus.

The Gold Fund is subject to the special risks associated with investing in gold and other precious metals, including: the price of gold/precious metals may be subject to wide fluctuation; the market for gold /precious metals is relatively limited; the sources of gold/precious metals are concentrated in countries that have the potential for instability; and the market for gold/precious metals is unregulated. In addition, there are special risks associated with investing in foreign securities, including: the value of foreign currencies may decline relative to the US dollar; a foreign government may expropriate the Fund's assets; and political, social or economic instability in a foreign county in which the Fund invests may cause the value of the Fund's investments to decline.

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