Slowly Unravelling!

By: David Chapman | Tue, May 27, 2003
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We can't help but notice that in our last few missives we have consistently talked about the unravelling of the US$. And numerous other pundits have written about the US$ in a similar vein. We even saw a television interview where financier-philanthropist George Soros told CNBC that he was short the US Dollar and long Gold. Usually when you see or read too many of these you begin to wonder whether a bottom may be near as the market is becoming too bearish.

But the few pundits muttering about the US$ and George Soros as influential as he is (remember that he was influential in the collapse of the British Pound back in 1992) are not the most important market. That belongs to the US Bush administration and they have stated (grant you obliquely) that a lower US$ would be good for the USA. Even Federal Reserve Chairman Alan Greenspan got into the fray with his mutterings on the threat of deflation. By allowing the dollar to decline you increase inflation (imported goods would be more expensive).

The coming collapse of the US$ will be the biggest currency crisis we have ever seen even though we have come off of a decade of currency crises. The British Pound collapse in 1992, the Mexican Peso crisis in 1994, the Asian Currency crisis in 1997 followed by Asian Currency crisis II and the Russian Ruble in 1998 are merely the big ones that plagued us during the 1990's. We also had the collapse of the Turkish Lira, numerous currency woes in Latin America and of course more recently the Argentine monetary and currency crisis. And here in Canada the fall of our dollar was often referred to as a crisis. During the 1990's it fell some 31% against the US$ to the lows seen in 2002.

Many of course rationalized the currency collapses as actually being positive. Here in Canada it was rationalized on the basis that it made our exports cheaper. But it probably has also made many a company less cost efficient as numerous were able to cash in on the cheaper dollar without actually changing how they operate. Of course they will pay for it now as the Canadian dollar rises. Most other countries were not so lucky and the currency collapse usually resulted in a visit by the IMF and stringent rules being placed on the country in order to recover from the resulting collapse. At least the IMF did not pay Canada a visit although we recall it being discussed.

There is no such thing as a declining currency being positive. That is why it verges on almost the perverse that a senior official of the Bush administration would be able to rationalize away a declining currency. For the USA the 1990's had been the decade of the strong dollar particularly from 1995-2002. It was a stated policy of the Clinton Administration to maintain a strong dollar. This played a significant role in making a contribution to the resultant tech bubble and financing the growing trade and current account deficit.

But today all that has changed. The trade deficit and resultant current account deficit could hit $600 billion/year over the next year. This means that roughly $2.4 billion in capital inflows is required each and every business day. And this says nothing of the financing requirements for the budget deficit that is projected to go over $300 billion this year and may even hit a record $400 billion all to finance record tax cuts and the war and occupation in Iraq. With low US interest rates and a falling dollar it will become increasingly difficult for foreigners to justify providing the necessary capital.

Falling interest rates in an environment of a falling dollar is not the easiest to understand. Normally interest rates rise to attract the necessary capital flows to finance the burgeoning trade and current account deficits. But over the past month US interest rates as measured by the long US Treasury bond futures have risen by $10 or almost 10%. In the record treasury financing seen earlier in May ($58 billion of which $55 billion was new money) the issue went far better than expected. This was attributed to the fact that the Japanese, who are key buyers of US Treasury bonds, participated fully. This was not what was expected as many felt that the falling US$ would prevent Japanese participation.

But the Japanese are concerned about the value of their currency. They are dependent upon their export economy to finance their own massive budget deficits. So the Japanese purchased bonds requiring them to sell Yen to buy dollars. This has worked to some extent as the Yen while up against the US$ has not rallied as strongly as the Euro or the Canadian dollar.

But this attempt by the Japanese to maintain their competitive advantage is not much different then an outright devaluation of their currency. This is what happened in the Asian contagion crisis of 1997 and 1998. Only this time it is different. Instead of the crisis evolving around a group of secondary currencies devaluing against the US$, the US$ is the world's reserve currency. Since central banks around the world hold their reserves in US$ this means that the value of their reserves are declining as well. We would not be surprised if many decide that it might be wise to hold more Euros or even gold as an alternative to US$.

But the US$ has not as yet hit a full-blown crisis. So far the decline is perceived to be orderly. Many admitted that the US$ had been overvalued for quite some time anyway. So the recent decline in the value of the US$ has not been surprising. What will be the surprise is when it turns into a full-blown crisis. We are not sure what might trigger that event but rarely has their been a declining US currency that has not eventually been accompanied by a crisis. We are all aware of the problems of the US$ in the past.

The 1970's decline in the US$ led to the explosion in gold prices to over $800. After a period of a rising US$ in the early 1980's concern shifted to the US$ being too strong. The Paris Accords in 1985 changed that then the burgeoning US trade deficit and the declining dollar in 1987 led to the stock market crash. After rolling around for the next number of years a sharply declining US$ in 1994 coupled with a collapsing bond market led to the strong dollar policy of the Clinton Administration of 1995-2000.

We have used the word slowly unravelling, as we do not expect this crisis to hit just yet although we could be surprised. It won't turn into a full-blown crisis until both the US$, and US stocks and bonds are declining at the same time. Right now that is not happening. But nothing illustrates better the ongoing crisis in the US$ and the subsequent rise in gold than the daily chart shown below.

While gold has been climbing its wall of worry it is worthy to note that the 200-day moving average has acted as good support continually over the past few years since the last bottom was seen in 2001. Conversely the US$ topped out roughly at the same time and it has had difficulty even surmounting the 50 day moving average since then.

While the US$ was enjoying a rebound at the time of the Iraqi war during March/April, gold was beaten back sharply. The US$ index is now in the throes of a possible fifth wave decline from the highs seen in early 2002. If that is the case a more serious corrective period could be upon us. Currently for the US$ we are at the levels seen during the 1998 crisis and this could act as a temporary level of support. As well we are hearing that the Exchange Stabilization Fund (also known as the Plunge Protection Team (PPT)) has been in the market recently to control the decline of the US$.

Gold meanwhile is below the levels seen in January/February when it soared to $390. We may yet see new highs in gold over $400 in this run but we are well aware that there is considerable resistance up to $420 dating from the 1996 highs. As well new highs now in gold would set up significant negative divergences in the weekly indicators. So we do need to be aware that a possible top in gold and bottom in the US$ could soon be upon us. But following a corrective period that could last weeks or even a few months the unravelling of the US$ should resume.

We have important turns for the US$ and Gold in the first two weeks of June. We would watch that period for signs of extremes in both gold and the US$. If on the other hand both are correcting the primary trend into that period (gold up, dollar down) then it may mean a resumption of the primary trend. Odds, however, favour a top in gold and a low in the US$.


David Chapman

Author: David Chapman
Technical Scoop

Charts and technical commentary by:
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David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund

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