Money Matters & Gold # 2

By: Ned W. Schmidt | Mon, Jun 28, 2004
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HEADLINE from 2008:
EUROPE'S PAPER PROBLEM
Paris Airport: Europe's paper problem: dollar bills. Today the first of weekly flights of chartered 747's will depart Paris for Washington, D.C. The cargo? U.S. currency being returned to the Federal Reserve. For months banks in Europe have had a problem. Citizens of all EU countries have been exchanging dollars for Euros, as acceptability of the currency has plunged. With vaults spilling over, banks are no longer able to store all that unwanted paper. The flights will depart weekly to carry the no longer wanted dollars for redemption. Only Gold will be accepted in the redemption, as few central banks will any longer invest in U.S. Treasury securities despite yields well in excess of 12% yield.

In the last issue of THE VALUE VIEW GOLD REPORT a graph was included about which the author has been thinking for some time. Some of my clients have been looking at this graph for years, baffled at why the author was so persistent on including it in the discussion. Sometimes one just has to look a long time at a picture before it becomes meaningful. That situation is surely true with something as exciting as the amount of U.S. currency in circulation. Yes, you have been waiting a long time for this though unaware of this internal craving.

We are going to be fairly pedestrian in going through some graphs. Few investors look at as many graphs as those interested in Gold and Silver. One almost needs a Masters in Graphing to get through some of the writings. Far those of you with advanced degrees in number theory please bear with us.

In the first graph we take a look at the relationship which is the source of our interest. The subject of our attention is U.S. currency in circulation. Those green pieces of paper, Federal Reserve notes, that you carry around in your wallets are about half of this. The other half is those green pieces of paper being carried around in the wallets of people all over the world. The U.S. dollar circulates around the globe. Those black triangles, using the right axis, represent the weekly value of U.S. currency in circulation. This number comes right off the Federal Reserve's balance sheet each week.

The other line in the graph is the year-to-year percent change in the outstanding amount of U.S. currency, and uses the left axis. As is readily apparent, the year-to-year change rose to a high level in the early part of the graph. That line has been falling in an irregular fashion since then. The pile of U.S. currency around the world is now growing at an extremely slow rate.

Reasons for the slower expansion of the U.S. currency supply are probably numerous. Debit cards certainly are more popular now than ever before. That development is acknowledged. However, when we look at this series compared to Gold the statistical evidence suggests that a conversion to the use of e-plastic money is only part of the development.

The high rate of expansion of the U.S. currency supply early in the graph coincides with the introduction of the physical Euro in the European Union. Many feared that calamity would occur with that event. Individuals probably converted to dollars to avoid the inevitable catastrophe, predicted by many British fear mongers.

Others likely feared revealing their cash holdings. Some around the world do not report all their income to the taxing authority, a practice we abhor in public. Cash transactions often occur to avoid the payment of confiscatory tax rates in Europe. These individuals certainly did not want to go into the bank with a large bag of marks or francs or whatever to convert into Euros.

As many know, taking bags of cash into a bank has not been acceptable for a considerable time. Some kind of explanation of the source of all those marks and francs might have been required. Many apparently converted their money hoards or business activities to dollars. In part, these transactions explain the weakness of the Euro during this period.

At this point we are going to digress for a small graphing lesson before going on to the heart of our discussion. Again, an apology to those well versed in graphics. In the next graph are two series. The top one is the normal view of the year-to-year percentage change in U.S. currency such as that which we looked at above. The second line is that series flipped over. We have done that simply by converting all values to negative. This convention will be useful later when we look at Gold.

Remember now a couple of rules when looking at this graph. The top line is the normal portrayal of the year-to-year change. When the rate of increase in U.S. currency is extremely positive, the confidence in the U.S. dollar is high. The U.S. dollar should appreciate and dollar Gold should be weak. When the rate of increase declines, confidence in the dollar is declining. The dollar price of Gold should be rising.

The reverse is true when we look at the inverted series. When converted to a negative, the greater the negative the greater the confidence in the U.S. dollar. In this type of period the dollar will appreciate and Gold should weaken. When converted to a negative, the less negative the lower the confidence in the U.S. dollar. In this latter case the dollar should depreciate and Gold should appreciate. The usefulness of this inversion will be obvious later.

Moving on, the foreign exchange market really functions on two levels. At the top is the institutional level where trades in the billions take place on a near continuous basis somewhere in the world. Around the globe, on electronic exchanges, these trades occur. With billions moving at the click of a mouse, these transactions are the ones that have the greatest influence on foreign exchange rates. These transactions take place in electronic money. Few of us operate in that market.

The other part of the foreign exchange market might be called the "street" market. Here is where individuals are making transactions. The tourist that trades currencies outside the airport is an example. Another is the merchant or individual in any country of the world that exchanges dollars for local currency or vice versa. These transactions take place in the form of paper money.

In the very first graph we looked at the divergence between the amount of U.S. currency outstanding and the year-to-year percent change is fairly obvious. You probably should take a look back at that graph. Divergence is when one series is going up and the other is going down. In that graph the size of the pile of U.S. currency is still rising while the momentum, year-to-year change, is going down. Declining momentum is a certain sign of change. This graph is a first class demonstration of the concept of divergence.

The change being read into this situation is that individuals around the world are desiring to hold less U.S. dollars than before. In the parlance of the economist, the marginal propensity to hold dollars is declining. Individuals are apparently more willing to hold some other currency. When we look at Gold, we will present a little evidence to support that conclusion.

What are they holding instead of dollars? Euros could be one example. Other currencies that have experienced improved confidence are possibilities. Perhaps they are holding Gold coins. Actually, we do not know what they are holding. All we know is that the marginal propensity to hold dollars is falling, and that their marginal propensity to hold some other currency is rising.

In the next graph we have plotted the monthly price of U.S. dollar Gold and the year-to-year change in U.S. currency circulation, inverted. Note that the year-to-year change is inverted. What we see is an extremely tight relationship between the year-to-year change in U.S. currency outstanding and the dollar price of Gold. The falling tendency to hold dollars on the part of individuals, for whatever reason, is being reflected in the rising dollar price of Gold.

In our previous article on money and Gold we talked about R2. That measure is the percent of the variance of the price of Gold explained by the variance of the year-to-year percent change in U.S. currency outstanding. Huh? It tells us how much the wiggles in Gold are explained by the wiggles in the percent change in U.S. currency outstanding.

About 75% of the wiggles in dollar Gold are explained by the tendency of world citizens to hold dollar currency. That suggests that the falling rate of increase in the amount of U.S. currency outstanding is a reflection of falling confidence in the U.S. dollar on the part of citizens around the world. This tight fit between the two suggests that the impact of e-plastic money does exist but is probably not the dominant reason for global individuals wanting to hold less dollars.

Around the world, the average citizens in a bazaar or the merchants in a city or unknown individuals in other countries may be less willing to hold dollars than was previously the case. The poor performance and poor fundamentals of the U.S. dollar have apparently reached wide and far. If these individuals, perhaps without the blessing of CNBC on a daily basis, know enough to not hold dollars, some of the rest of the world might be advised to listen up.

Our next step is to see what this declining propensity to hold U.S. currency means for investors. In a previous graph the close correlation between this tendency and the dollar price of Gold was noted. In the next graph we use this concept to look at the potential for the dollar price of Gold.

In the graph, the inverted year-to-year change in U.S. currency is advanced five by months. What this methodology does is show that what happens today influences tomorrow. In other words, today's falling marginal propensity to hold dollars influences tomorrow's dollar price of Gold. That series is shown by the squares. The black line is the dollar price of Gold. Notice again the tight fit.

We have also projected out, using black hourglasses, a possible path for the propensity to hold U.S. currency. This forecast suggests a likely path for dollar Gold. Again as we found in our last look at money, the argument for buying Gold is strong. Around the world individuals are shifting away from dollar bills to something else. That shifting demand for dollars has extremely positive implications for the dollar price of Gold. Kind of exciting when we find these relationships that point to the future.

At this point you should congratulate yourself. To your understanding of the world you have added an important, and not easy, concept. Tell your kids or grandchildren you studied the marginal propensity to hold dollars. They may look at you strangely, but just smile. This knowledge and your holdings of Gold and Silver mean you are way ahead of the bobbing heads on CNBC.

Everywhere we look, with one exception, positive indicators are found for the future price of dollar Gold. That one exception? Street research still is pushing paper assets, and those technology stocks. Why? They can create paper assets out of thin air and sell them to the gullible public. The Street can not create Gold. Given that truth, Gold is assuredly destined to rise in value more than paper assets. Stay on board for the ride to 1,200, for Gold in dollars and no doubt for the NASDAQ Composite Index too.

Given the positive outlook for Gold, you should be joining us and all the other "Gold bugs" as we seek out buying opportunities on the road to wealth preservation and financial prosperity.


 

Author: Ned W. Schmidt

Ned W. Schmidt,CFA,CEBS
The Value View Gold Report

Ned W. Schmidt,CFA,CEBS is publisher of THE VALUE VIEW GOLD REPORT and author of "$1,265 GOLD", published in 2003. A weekly message, TRADING THOUGHTS, is also available to electronic subscribers. You can obtain a copy of the last issue of THE VALUE VIEW GOLD REPORT at The Value View Gold Report. Ned welcomes your comments and questions, and tries to answer most all. His mission in life is to rescue investors from the abyss of financial assets and the coming collapse of the U.S. dollar. He can be contacted at ned@valueviewgoldreport.com

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