Moneyization Part Five

By: Ned W. Schmidt | Thu, Dec 23, 2004
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Moneyization: The global financial phenomenon of individuals and businesses moving their funds to monies in which they have the highest confidence, or money which has a higher store of faith. In money, only the fittest will survive.

The Federal Open Market Committee(FOMC), the monetary policy setting arm of the Federal Reserve System, recently raised interest rates by twenty-five basis points. This policy decision is consistent with their previously stated policy of raising rates in a measured fashion, or similar such meaningless words. While Wall Street has been happy with such a decision, a feeling of dismay would seem more appropriate. Speculators in paper equities seem joyed that another rate increase will not occur till February, while ignoring the implications of such policy. Gold and Silver investors have, by the continuation of this policy, had the wisdom of their investment decisions reconfirmed.

Two major problems exist with FOMC policy. Both inadequacies can be interpreted as positive for Gold and Silver investments. The recent announcement by the German bank of "measured" sales of German Gold is acknowledgment of the inherent dangers in U.S. monetary policy. Would the Germans be retaining their Gold if they thought the value of that Gold was going to fall? No, they too understand that the Federal Reserve will only make Gold more valuable. Holding Gold is certainly more appropriate than frivolously spending the sale proceeds on social programs in that country or investing in U.S. debt.

U.S. monetary policy continues to be set in global isolation. The Federal Reserve will not acknowledge that the U.S., as a participant in the global economic and financial systems, does not truly control domestic monetary policy. In the age of an electronic global world, operating as the Federal Reserve has means that either interest rates are going to rise or the national money, the dollar, is going to fall. Other possibilities are not within the set of consequences to this monetary policy.

In a world where capital is highly mobile, meaning money can move freely between most nations, central banks, including the Federal Reserve, lose their independence when it comes to monetary policy. When capital can move freely and exchange rates are set by the markets, the world dictates the level of interest rates for a nation. Now, a country can attempt to thwart this reality. A nation can make an effort to control interest rates within its domestic economy. However, the reality of such an effort is that the national money will eventually face devaluation.

Gold investors wishing to explore this "Unholy Trinity," as Cohen refers to this situation, may refer to either of his books listed at the end of this article. This situation is not unique in monetary history. Any experienced trader of foreign exchange recognizes the symptoms of the dangerous game being played by the Federal Reserve. The most recent period of weakness for the U.S. dollar is probably due to these informed market participants moving to avoid the U.S. dollar devaluation.

Devaluation, by the global foreign exchange markets, is a near inevitability given current Federal Reserve policy. The only policy choice left available to prevent such an event is to raise interest rates by a material amount. To thwart a dollar devaluation, the U.S. prime rate would ultimately have to be in double digits. Such a move is beyond the scope of reality for the Federal Reserve. So, the policy of "Intentional Neglect" for the U.S. dollar will continue.

The dangerous game being currency played by the Federal Reserve could also be referred to as "Equilibrium Management," and has a long history of repeated failure. Perhaps it could be also called "Managed Depreciation." Most banana republics have demonstrated that such policies are doomed. Apparently the U.S., now the world's biggest banana republic, is going to again validate again the widely recognized idea that competitive devaluations no longer work. This Federal Reserve has had its head buried in doomed policy sand for two decades. Why should they change now?

What is "Managed Depreciation?" The answer is that it is part of what we have already referred to as "Equilibrium Management." Remember that the Federal Reserve, and unfortunately most economic policy making entities, are dominated by economists trained in equilibrium determination and indoctrinated in discretionary economic policy. These descriptions are really not difficult to understand. What is scary are their implications for the economy and financial markets.

If you remember back to an economics class you might have taken, much time was spent on the intersection of lines in those graphs. Those points of intersection were considered equilibrium, where the markets were in harmony. Supply and demand, for example, were equal in some. Economics education focuses on those single moments of market happiness. Forgotten is that those ideal points only exist in the graphs, never in the real world. The real world is an ever changing, dynamic system. Each and every trade in a stock or a currency or Gold is an equilibrium price in the market. How long does that equilibrium price persist?

Students in economics have been taught that they can control the world through the wonders of monetary and fiscal policy. They can manipulate and control with such precision that markets can be held in equilibrium, and that the point of equilibrium can be manipulated. No longer is it believed by many that the markets have free will. Rather, the markets are subject to the decisions and desires of economic policy makers. Of course, all that is nonsense. Markets are more powerful than any group of policy makers. That, however, does not stop the Federal Reserve from attempting the economically impossible.

This monetary policy of a measured movement of interest rates is an attempt to move the U.S. economy into a state of managed equilibrium. The Fed is trying to raise rates enough to prevent the dollar from collapsing but yet keeping the U.S. economy expanding. The goal is to keep both the foreign exchange market and the U.S. economy at some mythical points of equilibrium. Only on the chalkboards in school and the muddled minds of managing economists can this be accomplished.

In the foreign exchange markets the value of the dollar is being allowed to fall. Higher interest rates are an experiment to see if the Fed can find that ideal mix of monetary policy where the dollar's slide is stable and prosperous economic growth are in sync. In short, the Federal Reserve is attempting to accomplish what no other central bank has ever been able to do. Hey, they have Alan Greenspan, a zillion computers, a great number of highly educated economists and the internet. What could possibly go wrong?

One of the many problems with this "fairytale monetary policy,"where everyone lives happily ever after, is reality. No matter how many computers they have, putting Humpty Dumpty back together again is not going to happen. The structural damage inflicted on the U.S. economy over the past two decades is probably irreversible. The structure of the U.S. economy has been seriously harmed by the diversion of capital funds to frivolous expenditures on housing and faster ways to apply for mortgages. The Fed has decided the U.S. would rather have DSL than jobs.

The Fed's "measured response" means no throttle will intentionally be applied to the U.S. economy. Consumers will continue to spend. Wal-Mart will continue as a giant vacuum for goods made in China. As long as the spending continues unimpeded by existing level of U.S. interest rates, the pressure on the dollar will be persistent. This Federal Reserve policy is an attempt to maintain indefinitely the current situation, massive spending on imports of foreign goods. All of that is good for dollar Gold, as it is bad for the dollar's value.

In Chart One we can see how the dollar price of Gold has been following the trend of the volume of goods being imported for U.S. consumers. The bars in the chart are the monthly level of U.S. imports, in billions, minus the energy related component, like oil. From each month's total imports is subtracted the amount spent on energy imports. Triangles, which use the right axis, are of the monthly average of U.S. dollar Gold. That the two seem to be moving together is fairly obvious.

As long as the Federal Reserve continues this "measured" policy, U.S. interest rates will remain below the level necessary to reduce U.S. imports. That situation means that an excess flow of dollars to foreign producers will continue unabated. The U.S. dollar will remain under "covert" selling and on a depreciating trend. Gold price of U.S. dollar will continue under pressure, and dollar price of Gold will rise further. In terms of the graph, the bars will continue to rise as well as will the triangles.

Moneyization of U.S. dollar holdings around the world continues in process. Individuals and businesses have developed an unwillingness to hold the dollar. They have been moving to national monies possessing a higher store of faith. Reluctance to hold dollars is high, and going to increase. That said, widespread selling of the U.S. dollar has yet to be evident in the data. Given the extent of the dollar's decline in a period characterized by reluctance to hold rather than a willingness to sell, the size of the ultimate devaluation of the dollar when selling does appear is certainly beyond any of the modest estimates being put forth.

Central banks continue to hold their U.S. dollar denominated investments. They do appear to be moderating their buying, as suggested by many reports. Chart Two shows the year-to-year change of holdings by official institutions of U.S. government debt on deposit at the Federal Reserve. While the year-to-year change has moderated, the recent level of holdings is still 270+ billion dollars more than a year ago. Also in included in that graph is the linear trend of the weekly change in those holdings plotted using the right axis. That trend is also negative, but does not yet indicate liquidation. In short, official institutions have moderated their buying of U.S. debt but are not yet selling. (How would you like to be one of those economists that wrote grand epistles about the wisdom of selling Gold and buying dollar assets?)

Two reasons exist for the lack of selling. First, the central banks, including the Federal Reserve, operate under the delusion, inspired by their staff economists, that the dollar's depreciation will be only moderate. Quite frankly they, central bankers, believe their own analytical nonsense. The dollar, in their view, will depreciate modestly, magically correcting the massive U.S. current account deficit. Other core beliefs include the Easter Bunny and their ability to put Humpty Dumpty back together again with their magical analytical super glue.

Forgotten in their analysis is that a large component of the U.S. current account deficit is structural in nature. In large part that unfortunate economic reality was brought on by the abnormal bull market for the dollar created by the Federal Reserve. If a U.S. consumer wants furniture for a new, but unnecessary, home that purchase will likely come from a foreign producer. That goes for many of the goods the U.S. consumer purchases. Due to the structural nature of the trade deficit, only a massive recession that seriously depresses consumer demand in the U.S. will effectively reduce the current account deficit. Which central bank will vote first for that option? Dollar devaluation is the only true alternative.

The second reason selling has not developed is that central banks do not want to increase the size of their losses on U.S. debt. Additionally, realized losses are always more painful to a central banker, or anyone it seems, that unrealized losses. What that means is that as painful as holding a depreciating asset might be, selling it and booking the loss is perceived as more painful. Additionally, they own so much U.S. government debt they do not want to make their losses larger. As we all have experienced some time in our trading life, panic selling will develop and likely after the price has dropped materially. Ever sell a stock out near the bottom? Same thing.

All these trends suggest that the U.S. dollar is not out of its bear market, but only that it has been in a rally from a short-term over sold condition. The U.S. dollar's bear market is real, and is still in puberty. When the selling of the dollar actually begins, time will be too late to buy Gold. The dollar price of Gold will be already up. One can not buy fire insurance with smoke coming out your front door.

Many words, most of them unsupported by real facts, are expended on what the central banks have been doing or will do with their Gold holdings. Thus far these commentaries and central bank actions have been a great set of contrary indicators. You can comfortably sit on your Gold until central banks start buying. As long as so many analysts are still worrying about central bank selling, your holdings of Gold are secure investments. They have been a consistent source of nonmaterial information.

Individual investors, however, must deal with their individual situation. In which currency an investor lives does have implications for whether or not to buy Gold at any one time. The world has only begun the process of repudiating fiat money. Your national money may or may not be in a position that makes Gold a wise purchase. On a regular basis our work now publishes recommendations for individual investors.

In the following table is listed a selection of the major national monies. This work focuses on the Gold price of a national money, not the price of the money in dollars. Remember, your national money could be appreciating against the dollar but depreciating in terms of Gold. The middle column in the table gives the trend for the Gold price of the money along with the ranking of that money against the others. In the final column is a recommendation on whether investors denominated in a particular national money should be buying Gold.

Selected National Monies
Gold Price Trends & Recommendations

National Money Recent Trend Gold Recommendation
Australia 7 Buy
Canada 8 Buy
Euro 3  
Mexico 6  
Russia 5  
South Africa 1  
Switzerland 2  
U.K. 4 Buy
U.S. 9  
Arrows indicate trend & number is rank.
Trends and recommendations are available
from THE VALUE VIEW GOLD REPORT.

With the wide spread introduction of Gold ETFs as well as the traditional forms of purchasing physical Gold, investors have little reason to accept the demise of their wealth by holding fiat monies. U.S. dollar-based investors are certainly the most vulnerable, but many others are at risk. Remember the important question. Will my national money exist ten years from now? Does anyone use the fiat money of the Russian Tsar?

As is apparent in the last chart, our intermediate indicator is working toward a buy signal. The short-term indicator, published weekly in our TRADING THOUGHTS, recently gave a buy signal. It is now working towards a modest over bought condition. That action likely will set the stage for a move to an over sold condition, and most importantly to a buy signal on the intermediate indicator. Such a set of conditions would suggest that U.S.$ Gold is preparing to begin another rally that will carry to a new cycle high in early 2005. Silver, high beta Gold, should also prove profitable during this period. Be prepared for the next leg in the Gold Super Cycle to US$1,300. Periodic comments, never as full as these articles or our publications, are now available at www.valueviewgoldreport.blogspot.com Feliz Navidad!

REFERENCES:
Cohen, B. J.(1998). The Geography of Money. Ithaca: Cornell University Press.
Cohen, B. J.(2004). The Future of Money. Princeton: Princeton University Press.


 

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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