So Here’s The Thing About the US Dollar, and Gold

by JDH on September 26, 2009

So, here’s the thing.

Since March 6, 2009, the S&P 500 Index is up over 53%, and the rise has been very steady, with virtually no breaks.

SPSept24-09

That’s a very impressive rally, and it’s a rally that I have totally missed. I didn’t expect it. (Actually, I don’t recall anyone, on March 6, predicting a 50% increase before the end of September). I didn’t expect it because, usually, it takes about three years into a recovery for the markets to bounce back 50%. And usually a recovery is accompanied by rising employment.

We have had neither a recovery, or rising employment.

So here’s the thing:

Two years ago, when this whole “credit crunch” thing started:

  • The Fed funds rate was over 5%; today it’s around zero;
  • You could get a 30 year fixed mortgage rate for 6.75%; today, around 5%;
  • The Fed’s balance sheet was a mere $850 billion; today, over $2 trillion, and growing fast;
  • The fiscal deficit to GDP ratio has gone from 2% to 13%.

Yikes.

But wait, it gets better. The Broad Trade Weighted U.S. Dollar Index, is a measure of the value of the US Dollar relative to other world currencies. The math is quite complicated, as shown by this formula, where the index value at time t is given by this formula:

TWUSD-Formula

For those of you who don’t get the formula (which would include me), in simple terms the exchange rates of around 30 currencies, weighted based on each countries’ level of trade with the U.S., are compared to the U.S. dollar, to generate the index.

Now, here’s the thing (in chart form):

Trade-Weighted-US-Dollar

According to the Federal Reserve Bank of St. Louis (go to their web site and create your own charts; it’s fun), the TWEXB is around the 103 level, which is exactly where it was at this time last year, and exactly where it was at this time two years ago. (Okay, maybe not exactly, but pretty close: look at the red and green lines in the chart). Isn’t that amazing?

I can see by the glazed over look on your eyes that you have no idea what I’m talking about, so let’s start from the beginning:

Pretend you are Mr. Obama, leader of the free world. You inherit the worst depression in three generations. You need to fix it. So you do what rulers do: You lower interest rates, and you spend tons of stimulus money. And for a short period of time it starts to work. Confidence starts to return. The stock market goes up 50%. Things are looking good.

But here’s the thing: The unemployment rate in the U.S. is almost 10%, as shown in this chart, thanks to Google (is there nothing that Google doesn’t know?):

10% is higher than it’s been in forever. And when you factor in all the people who are working part time, or are under-employed, or who have given up, the numbers are really big. Since WWII the highest unemployment rate is 10.8%, so we are within spitting distance of a disaster.

By disaster, I mean if you are the leader of the free world, and you want to implement an ambitious health care plan, and a climate change plan, and a bunch of other plans, you must win the mid term elections next year. And it’s really hard to win elections with record unemployment, because those unemployed people actually have time to vote. Last year you could blame George W for the mess; that will be much harder to do two years after George Jr. departed, and after two years of stimulus that was supposed to fix the economy.

It’s a disaster, because the last guy who had visions of health care plans dancing in his head, Wild Bill Clinton, got creamed in his first mid term elections, circa 1994, and The Big O doesn’t want that to happen to him.

So, for the two of you who are still with me, let me pull this together for you:

Bad unemployment. Can’t get my party re-elected next year if there is high unemployment.

Tried to fix it with low interest rates and high spending. Didn’t work.

That leaves only one last thing to try:

Kill the dollar. Or, more specifically, devalue the dollar. Just like our old pal FDR did to end the Great Depression when he bumped up the official price of gold from $20.67 per ounce to $35 per ounce, so to will our modern day FDR, a.k.a. BHO, do the same.

(You can do your own research on this one, but there are lots of interesting articles out there, like this one, or this one, or this one, or this one).

Yes, devaluing the dollar is inflationary, and has a lot of other bad consequences, but the one sure “cure” for falling house prices and general deflation is inflation.

Just think about it: if every dollar was instantly worth $2, then the real estate value in the mortgage bank’s portfolios just got twice as valuable. The mortgage values are fixed, so instantly there is equity in their portfolios where before there were huge losses. Beautiful. Plus your house price went up, so you feel good again, and you start spending.

Remember this chart:

Trade-Weighted-US-Dollar

The only metric that has remained the same for the last two years is the U.S. dollar. The only thing left to try, since massive spending and reduced interest rates didn’t do it, is to devalue the dollar.

Of course everyone knows it’s coming. China is moving to convert it’s dollars to other currencies, and to hard assets like gold.

So what do you do? How can you protect yourself when the paper you are holding is losing value?

You know the answer: buy gold. The government can’t print gold. They can’t devalue gold. Or silver. Or uranium. Or any other hard asset.

Of course 2009 is not 1932. We don’t have fixed exchange rates, and we aren’t on the gold standard. The government can’t simply change the exchange rate. But devaluing the dollar can be done in many other ways, and it will, because it’s the last thing to try.

Last week I said:

A pullback to below $1,000 would not be surprising. Even a pullback to $950 would not shock me. So my plan this week? I will place some stink bids below where we are trading now, and continue buying on big drops. Then, two weeks from now, on up days I will do what I did this month: selling calls, out of the money, on my positions. I will continue to pocket premiums until we get through the expected market weakness in October and November, in anticipation of better things ahead in 2010.

Well, not surprisingly, gold pulled back this week. And I started nibbling to increase my gold stock holdings. And I plan to continue buying in what will presumably be a weak October and November.

The train has left the station. The dollar must be devalued, and gold must therefore increase. I don’t know the exact timing, but I’m willing to be patient and wait for the inevitable.

Thanks for following my rambling explanation of my cloudy crystal ball. See you next week.

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