Gold prices surged to a record high $1226.10 an ounce on Dec. 3, but have since retreated. Meanwhile, the U.S. dollar has been weak for many months, but shown signs of strength in the past week.
So what's next for the dollar and the price of commodities like gold?
In order to answer that question we must look at the factors that brought us here: loose monetary policy and government stimulus.
When the global banking system seized up last year, governments met in global forums and loosely coordinated a mammoth response to the economic chaos. On the fiscal side, governments turned to counter-cyclical spending. And on the monetary side, central banks, including the U.S. Federal Reserve, dramatically reduced interest rates and actively engaged in money printing.
In fact, the United States is out in front of the pack in terms of money spent and printed.
More prudent emerging markets fell back on the large piles of international reserves they accumulated in the commodities bull and leaned heavily on the strong fiscal and current account surpluses that they took care to build after the emerging market crises of the late nineties.
Their central banks eased monetary policy, but did not have to resort to the same kinds of large cash infusions as central banks in developed countries.
Brazil, for example, was able to absorb the shock by allowing its currency to devalue, easing its very tight monetary policy, and increasing spending. It was the last Latin American country to enter a recession and the first to return to growth.
China had an even stronger external and internal position. It was able to press on the monetary and fiscal accelerators and will likely reach double-digit economic growth this quarter. The disappointment with China is the government's continued intervention in the nation's currency to prevent it from realizing its true value.
Of course, the United States was in a much more difficult position and naturally took more debt and printed more money to overcome its economic challenges.
The housing bust in the United States had terrible consequences. Weak banks and weak financial players collapsed. And the banking system and the shadow banking system of finance companies and hedge funds were suddenly forced to reduce their outrageous leverage. This abrupt withdrawal of credit brought the economy to a standstill.
Americans held some 70% of their wealth in their houses and some 20% in the stock market. With home prices down an average 15% nationwide and much larger stock market losses, savings were decimated.
The ensuing recession brought unemployment up to about 10%, and the U.S savings rate rose to some 8% of income, up from -2% of income prior to the crisis. The latter is actually a welcome development for the United States, because savings typically leads to investment and investment leads to growth.
The biggest risk for the government and the Fed continues to be the economy falling into a deflationary spiral. That spiral would occur if expectations of generalized deflation lead people to remain in cash, even receiving zero interest, instead of putting their money to work. This would be a nightmare for any central bank, because as asset prices would keep dropping, people would keep defaulting on their obligations and more pressure would be put on banks. Banks would have to stop credit, which would further hamper economy and reinforce the down cycle in asset prices.
That's why the Fed has been extremely vigilant and active at fighting this possibility. The central bank first restored confidence in the banking system and interbank lending. Then, it moved to the rest of the money markets and some key classes like credit cards, auto loans, student loans and asset backed securities. Meanwhile, the massive fiscal stimulus and programs like "Cash for Clunkers" helped fund economic activity and save jobs that would not have come about otherwise.
But the problem here is the cost of all this. Since the government is taking on debt to fund its huge fiscal deficit, the interest cost will put pressure on the economy for decades.
Europe also resorted to massive bank bailouts and fiscal and monetary stimuli, albeit less than in the United States. Europe and Japan have also shown signs of economic recovery, to the point that the European Central Bank (ECB) is considering the withdrawal of monetary stimulus.
But the recovery is still fragile everywhere and it has largely been driven by the colossal amount of money being spent, whether it was saved, printed, or borrowed.And some countries may now try to manage the process in their favor.
For example, the dollar's decline against the euro and yen is hurting European and Japanese exports. This is likely to result in Europe tightening its monetary policy later than otherwise. In the case of Japan, that nation's central bank actually injected cash recently and very vocally indicated that the level of the yen was hurtful. In addition, the Bank of Japan (BOJ) indicated it might take other measures to prevent the yen from further appreciating.
Europe and Japan have traditionally tried to export their way out of trouble. That was okay when the U.S. economy and emerging economies were vibrant. But now, this poses a problem. Europe and Japan should do more to boost internal consumption, rather than relying on exports. And in Europe, the problems with Greece and Spain will force the ECB to delay tightening its monetary policy.
In the meantime, we need to think that the wall of money coming from the Fed and the U.S. government as temporary "steroids" that need to be removed at some point. And that is where the really difficult trick lies: If the Fed raises interest rates and withdraws stimulus too soon it could stall the fragile U.S. economic recovery. But waiting too long to boost rates could allow ruinous inflation to take hold.
Lately, the Fed has been signaling a divergence from its liquidity policy. While interest rates will remain very low for an extremely long period of time, the new development is that references to quantitative easing have disappeared. With the banking collapse largely contained, the Fed is stepping back very slowly.
Couple this with the fact that we are close to the end of the year and many are sitting on huge profits in commodities and other assets. The trade – called the dollar carry trade – has been to borrow dollars and buy the world, especially hard assets. This trade replaces the yen-carry trade of the past decade, since now it is more advantageous to borrow dollars.
So, much like the yen carry trade reversed very close to the Japanese fiscal year ended March 31 only to be put back again starting on April 1, the dollar carry trade is reversing as we speak and will be put back in again starting January 2.
However, 2010 will see a lower deployment of the dollar carry trade than 2009, because valuations are higher and less liquidity is available. In addition, the risk that the Fed starts removing more liquidity from the system will be much higher than in 2009.
Hence, I believe it will work to a lesser degree than in 2009.
So, with gold, we are seeing a reversal due to this trade unwinding temporarily. Use it to buy some gold closer to the end of the year. Policies still will remain very lax globally, which will help gold.
Recommendation: Buy SPDR Gold Trust ETF (NYSE: GLD) at market towards the end of the year (**).
(**) – Special Note of Disclosure: Horacio Marquez holds no interest in iShares SPDR Gold Trust ETF.
News and Related Story Links:
- Money Morning:
Buy, Sell or Hold: The SPDR Gold Trust ETF (NYSE: GLD) Continues to Offer Investors a Hedge Against Inflation.
- Money Morning:
Buy, Sell, or Hold: iShares SPDR Gold Trust ETF.
- Money Morning:
Fed Maintains Monetary Policy but Eyes Inflation in the Offing.