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News, Commentary & Analysis
Celebrating our 39th year in the gold coin & bullion business
Michael J. Kosares, Editor
October 2012

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Dollar Index Disguises Global Inflation Threat

by Jonathan Kosares

When the U.S. Dollar Index peaked at 120.51 in January of 2002, few suspected that it was on the brink of a one-directional correction that would ultimately erase a third of its value.  In fact, in just three short years, the dollar index shed, on average, a point a month before ultimately hitting a low of 80.77 in January of 2005.  This sharp decline in the dollar index coincided with, and largely fueled, the first few years of the now decade-old bull market in gold.  Those participating in the gold market in those first few years were taught ‘at a young age’, so to speak, that the dollar and gold were inseparably linked.  If one wanted to know what was going on with gold, one would look no further than the dollar index.  If the index fell, gold would rise, and if it rose, gold would fall.  Even today, financial media outlets still ‘explain’ the daily movements of the gold price in this same context of corresponding activity in the dollar index.  If the dollar index is so important to predicting and explaining the value of gold, then how does one explain that seven years after hitting the low of 80.77, the dollar index is still trading in the same range - just above 80 today - yet gold has quadrupled?


Dollar Index

Simply put, the long accepted inverse correlation between the dollar index and the gold market is flawed and needs to be abandoned.  Not just because it fails to explain the last seven years of gold’s performance, but it stands to only become more irrelevant, and even potentially misleading, moving forward. 

Here’s why:

Generally, individuals equate the dollar index to some representation of the value of the dollar.  With financial media coverage on the dollar focusing on the performance of the dollar index, it’s hard not to fall into that trap.  And it is partially true.  The dollar index is meant to be a strength/weakness indicator for the dollar in terms of the other major currencies.  If the index rises, the dollar is strengthening against those currencies.  Conversely, if it declines, the dollar is weakening against those currencies. But what matters to main-street is not whether the dollar is ‘strong’ or ‘weak’ because, in reality, those words are nothing more than impractical rhetoric.  What matters is the value of a dollar in terms of what a consumer can buy with it.  What is important is not confusing this practical understanding of the dollar’s value with the nebulous data embodied in the dollar index. 

A quick example: 

According to the Bureau of Labor Statistics (BLS), approximately 35% of the average American’s income is spent on housing.  The next two largest expenditures are for transportation (16%) and food (14%).  Given the share the cost of energy has in both housing and transportation expenditures, it cannot be disregarded as a significant outlay for Americans, though it isn’t given its own place in BLS reports.  In looking at a graph of various food and energy prices (both gas and electricity) since January of 2005, it is clear that the dollar has lost considerable value against a sizeable swath of everyday expenditures.  This tells a decidedly different story than seven years of a functionally unchanged value in the dollar index.

Price Change of Everyday Expenditures

A simple gut check will tell you that this is a consistent theme across nearly all goods and services, not just what’s listed here.  On average, the items charted above are 45% more expensive than they were in January 2005, with gasoline costing double.  So, in just seven years, the dollar has lost about one-third of its spending power, its practical value, when measured against some of the most common goods purchased by the average family.  On a side note, food and energy are the two components specifically excluded from core CPI as they are said to be ‘too volatile’, offering some insight into how incomplete core CPI figures are as a practical measure of inflation.

And if you want to see where the dollar has really lost ground during this period, look no further than gold.  Gold has quadrupled since January 2005, suggesting that in terms of its spending power against gold (which happens to be one of the only vehicles that has kept up with, and actually outpaced, food and energy inflation), a 2005 dollar is currently worth 24 cents. 

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The dollar index, financial media will tell you, is maintaining persistent strength, largely due to constant failures and disruptions in the Euro Zone, affecting the value of the euro and pushing ‘safe-haven’ flows into US Treasuries.  Every now and then we still hear some ‘strong dollar’ rhetoric.  What’s taking place behind the scenes is a full-fledged currency war, as countries seek to lower the value of their currency to relieve debt burdens and encourage economic growth through export markets.  In essence, currencies appear to remain somewhat constant in value vis-a-vis one another, masking the across-the-board devaluation in terms of their individual spending power. 

The net result is that the dollar index remains tightly bound in its range, as do all of the other currencies, yet all devalue against real goods and services.  As currency wars ramp up, the nominal values applied to currencies in this model will become increasingly irrelevant and misleading. In fact, one could argue, given its decline across so many areas, that a collapse in the value of the dollar is already taking place, and it is being disguised, not displayed, by the dollar index.

Which brings us to gold.  Anybody who believes the next leg of the bull market in gold needs to see a decline in the value of the dollar index as its impetus ought to rethink their analysis.  Whether the dollar index falls to 70 or rises to 90 is of little consequence to the gold market.  So long as international devaluation policies remain in place, the gold bull market will continue.  The value of the dollar index will be nothing more than a representation of who is winning the war…a sort of scoreboard for the ongoing ugly contest between government-issued currencies. 

Addendum:  A couple of interesting quotes drawing on the theme of this article came out over the weekend: First, Ben Bernanke:

“However, since mid-2008, in fact, before the intensification of the financial crisis triggered wide swings in the dollar, the real multilateral value of the dollar has changed little, and it has fallen just a bit against the currencies of the emerging market economies." 

 

Second, Brazilian Finance Minister Guido Mantega:

 “I have been arguing that ‘currency wars’ will only compound the world’s economic difficulties.  Trying to grasp larger shares of global demand through artificial means has many side effects. It is a selfish policy that weakens the efforts for concerted action.” 

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Global Growth Risks Mount

by Peter Grant

Last week we saw of raft of negative economic assessments:

The World Bank lowered its outlook on Asia, citing the "considerable risks" to export demand posed by the eurozone debt crisis and the looming U.S. fiscal cliff. The World Bank now expects 7.2% growth in the region for this year, down from 7.6% forecast in May. That revised estimate is an 11-year low. The bank's 2013 projection was lowered to 7.6%, from 8.0%.

The Asian Development Bank (ADP) provided an even weaker assessment of Asia, although it take a broader look at the region than The World Bank. The ADB is calling for just 6.1% growth in 2012 and 6.7% next year.

The IMF is now saying that global growth will be 3.3% this year and 3.6% in 2013. Both are downward revisions from their April forecasts of 3.5% and 4.1% respectively.

This all comes on the heels of a number of negative revisions to U.S. Gross Domestic Product (GDP) forecasts, including some from the Fed itself: At the September Federal Reserve Open Market Commitee meeting, the 2012 projection was lowered to 1.85% (midpoint of central tendency range), from 2.15% in June. While the 2013 outlook edged slightly higher to 2.75%, versus 2.5% in June, the long-term central tendency range remains a narrow and anemic 2.3%-2.5%.

The Brookings Institution-Financial Times TIGER (Tracking Indices for the Global Economic Recovery) index reveals waning global economic momentum as well. In a recent FT article, Professor Eswar Prasad of the Brookings Institution, said: "The global economic recovery is on the ropes, battered by political conflicts within and across countries, lack of decisive policy actions, and governments' inability to tackle deep-seated problems such as unsustainable public finances that are stifling growth."

When Professor Prasad speaks of a "lack of decisive policy actions," I presume that he's speaking of fiscal policy actions, because the monetary policy actions of global central banks have been nothing short of mind-blowing.

Chart by Also Sprach Analyst

Given the unprecedented monetary policy response over the last several years, what's really astounding (or perhaps not…) is the absence of results on the growth front. Of course, the king of expansive monetary policy by the 'percentage of GDP' metric is China, as this second chart by Also Sprach Analyst clearly shows. However, interestingly the Peoples' Bank of China's (PBOC) balance sheet has been shrinking at an accelerating pace lately, primarily as Also Sprach Analyst points out, because as the "Chinese economy continues to grow fast (for now), the net result is that the size of PBOC's balance sheet is shrinking relative to the economy."

Chart by Also Sprach Analyst

The World Bank assessment suggests that there is room for additional fiscal stimulus in Asia, and the PBoC hinted at as much over the summer. However, make no mistake, if Chinese manufacturing and exports continue to slow to the point where unemployment starts getting uncomfortably high, the PBoC would likely have a monetary policy response as well.

In the U.S., the lack of progress on the growth front (and the recent weakness in the U.S. stock market), despite nearly 4-years of extraordinary monetary policy measures may also incite the Fed to exercise the pledge in the last FOMC statement to "undertake additional asset purchases, and employ its other policy tools." There is perception out there that the Fed may resume outright Treasury purchases if the economy (and stocks) continue to languish.

Former Wyoming Senator Alan Simpson said on CNBC last week, "If you want to know about a stimulus, whether you're listening to (economist Paul) Krugman or whoever, we do a pretty good stimulus. It's called the deficit — one trillion, 100 billion bucks. What the hell do you think that is?" The co-author of the Simpson-Bowles debt reduction plan makes a good point: We've been running $1 trillion plus deficits for the last four-years...on top of what the Fed has been doing. That the economy remains moribund nonetheless, speaks to how dire the situation really is.

Ongoing deficit spending, along with a myriad of other global stimuli, and the likelihood of further monetary accommodations from the central banks of the world, should continue to debase global currencies and underpin the gold market. Robust investment and sovereign demand for the yellow metal is expected to continue to provide support to the market as well. That means that recent losses are merely corrective in nature.

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Supply Issues Offer Additional Underpinnings to Gold

by Peter Grant

Gold has turned defensive over the past week. However, downside potential is thought to be limited by continued robust demand for the precious metal as a hedge against the global debasement of fiat currencies, as well as ongoing central bank demand for the purposes of reserve diversification.

Most of our readers are probably pretty well aware of these macro-drivers on the demand side, but it's also worth noting some significant supply side considerations:

First of all, and this is a topic we've discussed on numerous occasions, none of the mining supply from China is making it to the open market. Essentially, every ounce of gold mined in the world's largest producer is going right to their insatiable reserve building effort.

Secondly, the fourth largest producer in the world is also in full-on accumulation mode. According to the World Gold Council Russia has more than doubled its gold reserves in the last five years and now holds the fifth largest stockpile. It is likely that much — if not all — of their mining output is going right to reserves as well.

Thirdly, more recently, labor unrest in South Africa has negatively impacted production in the fifth largest producing nation. Reuters reported last week that strikes were costing AngloGold 32,000 ounces of gold each week, while Gold Fields is losing 2,300 ounces a day at the two mines affected.

Gold Production by Country

It's difficult to assess how long the labor unrest might last, but after just two-months, there is already talk of possible negative revisions to South African GDP. According to Reuters: "Wildcat strikes that started in the platinum mines have left more than 50 people dead and spilled to other industries, undermining investor confidence in Africa's biggest economy and tarnishing President Jacob Zuma's government."

Just to round out the list of top-five gold producers: Australia comes in at number-two and the United States in number-three. But the take-away here is that nearly a third (28.3%) of global gold production is being impacted either by sovereign reserve building or labor strife. That's huge.

So while supply issues often get short-shrift in the financial press, it's important to realize that they too provide significant underpinnings to this market. Simple supply and demand economics, strong demand relative to available supply, suggest that the long-term secular bull market remains dominant and that short-term corrective activity should continue to be limited and short-lived.

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Sifting Through the Silver Hype

by Jonathan Kosares

After breaking from their year-long consolidation in mid-August, gold and silver have both shown nice gains over a short period of time, though silver is clearly leading the way.  At the time of this writing, in just the past two months, gold has appreciated 10.7% and silver 27.5%.  Because silver outperformed gold by such a wide margin, it has initiated a new wave of silver-bullishness that is reminiscent of the euphoria we saw last spring when silver charged to just shy of $50 an ounce.  In conjunction, we’ve seen a spike in silver inquiries here at USAGOLD as well.  Most clients ask us if we believe silver will continue to outperform gold, and why. 
                
The short answer is, maybe.  Gold and silver share a strong positive correlation (meaning they tend to move in the same direction), though silver is an inherently more volatile metal.  Given its bulk, it trades in far smaller volumes in the physical market than it does in the paper market.  It truly is a market characterized by ‘the tail wagging the dog’, a reference to the idea that leveraged paper positions dwarf the volume of physically traded metal.  Given the broader availability and simpler liquidity of paper positions, they can be purchased and sold much more quickly and cheaply than physical positions.  The net result is magnified moves, in both directions:  When moving higher, silver does often go up faster than gold, but for the same token, when moving lower, silver also tends to go down faster. 

So how then, can one buy silver ‘right’, and specifically mitigate the negative consequences of this volatility?  We believe a deeper understanding of the gold/silver ratio will enable buyers of silver to enter long-term positions that maximize their opportunity to succeed.  The gold/silver ratio takes the gold price and divides it by the silver price.  It is essentially the number of ounces of silver it takes to buy a single ounce of gold.  

Here is a graph showing the gold/silver ratio over the last 12 years: 

Gold/ Silver Price Ratio since 2000

A couple of points worth noting:  The average gold/silver ratio over the period of this bull market has been just shy of 60:1.  There have obviously been numerous times where silver was quite a bit weaker than gold, reaching its weakest in 2009 at just over 80:1.  Going the other direction the ratio has only dipped below 50:1 a handful of times, and moved below 40:1 just once, during the run up to $49.77 last April.  Obviously, the simple guidance would be to buy closer to the average.  In doing so, you stand a better chance to participate in a move in the ratio that favors silver, while limiting your exposure to a weakening of the ratio.

silvercoinsIn just about any discussion of the gold/silver ratio, 16:1 will be mentioned.  It is largely a reference to the 1800’s, when the United States operated on parallel gold and silver standards and the ratio was set at 16:1 by Congress.  In fact, for much of recorded human history, the gold/silver ratio was held at, or near, these levels.  But that said, any time silver was demonetized and traded solely for its commodity value in a free market environment, the ratio remained substantially weaker.  This is how silver is traded today.

Barring a government re-monetization of silver, it is unlikely we will see 16:1 again.  The only free market moment where the ratio was close was when the Hunt brothers famously tried to corner the silver market in the early 1980’s.  The next closest move was the acceleration to $49.77 last April.  Setting realistic expectations of the gold/silver ratio is critical.  Given the low probability of a return to the historic ratio of 16:1 and the very limited time spent below 40:1, it would be logical to conclude that a purchase of silver anywhere from 40:1 on into the 30’s is very likely one that would occur ‘far too late’.  To the point, when silver topped out last April, the ratio touched 32:1.  In just two weeks after peaking, silver shed $17 in value, and the ratio returned to 45:1.  Conversely a purchase closer to 60:1 logically leaves more room for the ratio to improve in favor of silver.  True to this analysis, in mid August just prior to this latest move higher, the gold/silver ratio touched 58:1.

So what about right now?  The current gold/silver ratio is 52.25:1. Given the historic range, it is safe to say this is a reasonable time to buy silver, though not necessarily an undeniably great time to do so.  A purchase in the low 50’s leaves a seemingly equal amount of room for the ratio to improve as it does for it to decline.  In other words, it is somewhere ‘in the middle’.  That said, we view silver the same way we do gold, as a long-term savings vehicle that is a nice companion to gold in a precious metals portfolio, especially from the standpoint of increasing the negotiability of your holdings.  Given silver’s volatility, we caution aggressive allocations, especially for individuals using precious metals ownership as a protective/asset preservation strategy.  In short, don’t go ‘all-in’ on the hype. 

The information presented here is not trading advice, nor does it represent a trading strategy, and we do not encourage speculation.  Please also note that the ratio could improve in an environment where both metals lose value.  In other words, buying at a time when the ratio is weak does not ensure positive gains in the future.  In short, this analysis is intended to provide our clientele a useful tool in establishing prudent long-term physical coin and bullion positions in gold’s kindred metal. 

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Jonathan Kosares graduated cum laude from the University of Notre Dame with a dual major in Finance and Computer Applications. He has been with USAGOLD since 2002, and currently holds the position of Executive Vice President of Sales and Marketing. He is the moderator of the USAGOLD RoundTable series, has authored numerous articles on the gold market and manages client activity for the high net worth division as well as the USAGOLD Trading and Storage Program.

Peter Grant spent the majority of his career as a global markets analyst. He began trading IMM currency futures at the Chicago Mercantile Exchange in the mid-1980's. Pete spent twelve years with S&P - MMS, where he became the Senior Managing FX Strategist. The financial press frequently reported his personal market insights, risk evaluations and forecasts. Prior to joining USAGOLD, Mr. Grant served as VP of Operations and Chief Metals Trader for a Denver based investment management firm.

This newsletter is distributed with the understanding that it has been prepared for informational purposes only and the Publisher or Author is not engaged in rendering legal, accounting, financial or other professional services. The information in this newsletter is not intended to create, and receipt of it does not constitute a lawyer-client relationship, accountant-client relationship, or any other type of relationship. If legal or financial advice or other expert assistance is required, the services of a competent professional person should be sought. The Author disclaims all warranties and any personal liability, loss, or risk incurred as a consequence of the use and application, either directly or indirectly, of any information presented herein. Opinions expressed by contributors are strictly their own and publication here does not represent endorsement by USAGOLD.

Editorial questions and comments:
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