Forex Robot: Gold History Dominates The Dollar

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TheLFB Daily Client Note
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Client Note: U.S. Session Review

March 28, 2011
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Dear Trader,
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Trade Desk Note
Gold History Dominates The Dollar
As the price of gold has pulled back from its recent run up to $1,440 and silver
continues its meteoric rise, investors are left to ponder what exactly drives the
movement of such an important and financially sensitive commodity, and how bullion
trade impacts the mid-term outlook for the US dollar. Most people are aware that
gold prices respond to inflation expectations and that central banks, as the largest
holders of gold, are big players in the market. But there is not always clarity
in understanding as to why and how these players affect prices, and what their ultimate
goal may be.
Although few people actually know how central bankers from Bombay, Berlin and Beijing
look to manage the global gold market, a better understanding of how our current
system came to be provides some clue about gold's recent behavior. The First World
War was not only catastrophic to an entire generation of Europeans, but it also
left the international financial system in tatters. After the war, the great powers
met in Rome to re-establish a workable international financial system. The British
pound sterling, which had always been fully convertible into gold, was selected
as the official 'reserve currency.'
During the Great Crash of the 1930's, the collapse of Austrian and German banks
triggered a run on sterling for conversion into gold. Unable to withstand the assault,
sterling was replaced as the reserve by the U.S. dollar. Although the dollar was
also convertible into gold, the Roosevelt administration had limited the risk to
the U.S. Treasury by restricting redemption only to central banks.
In 1944, the newly established International Monetary Fund (IMF) selected the U.S
dollar as its 'international reserve asset', which enshrined a quasi-gold standard
to undergird global financial transactions. However, the inflationary policies of
most governments caused the market gold price to rise above the official price of
$35 an ounce.
In 1961, as the price of gold drifted higher relative to the dollar, the major central
banks formed the London Gold Pool, a 'gentleman's club' to coordinate gold sales
in order to stabilize gold prices. But by 1971, the dollar's devaluation had overwhelmed
their coordinated interventions. Ultimately, President Nixon was compelled to break
the dollar's last links to gold by closing the 'gold window' to other central banks.
For the first time in fiscal history, the world monetary system 'floated'.
Since then, major central banks have continued to debase their currencies at pace
with the U.S. dollar. In 1978, via the IMF, there was a move to demonetize gold,
which stood to expose the true rate of consumer inflation. This was first carried
out by massive central bank sales of gold in exchange for Special Drawing Rights
(SDR's) from the IMF. When this failed, the U.S. gained support, in 1999, for the
Central Bank Gold Agreement (CBGA) to coordinate the release of central bank gold
into the market.
Officially, at least, this was meant to prevent central banks from dumping gold.
However, it is highly suspicious that these nominally independent central banks
would take coordinated action to support the gold price. This is especially true
given that they've spent the last forty years trying to do the opposite. It is likely
that the CBGA was designed to covertly time purchases and sales to magnify gold's
price volatility, in order to dissuade investors from holding it over the long term.
This intervention was probably the biggest factor in distorting the gold market,
but the precious metals investor should understand that central banks can only
pressure the market, not dictate it. Gold will continue to move higher as the following
dynamics unravel.
First, the dollar has benefited from its reserve status, which creates demand for
dollars to complete various transactions. However, the conditions that put the dollar
on the world monetary throne have already changed, and it's just a matter of time
before it is forced to abdicate. Just as French endured as the international diplomatic
language long after France waned as a world power, so too is the dollar coasting
upon its former glory. When the dollar loses its reserve status, overseas demand
for the greenback will decline and a reserve of a mix of bullion, rare earth, and
precious metals will likely flourish.
Second, many holders of surplus currency have diversified into the euro. But the
euro is a tower built on a potentially unlevel ground. Already it is showing cracks
as Greece, Ireland, Spain, and Portugal exhibit signs of economic failure, along
with a banking sector that although strong is now susceptible to new balance sheet
standards criteria being implemented. If the solvent states of the union succumb
to pressure to bail out their weaker neighbors, the euro will lose a part of its
newfound credibility in the global arena.
Third, the U.S government and Federal Reserve have been successful in distorting
the official inflation figures, and at times attempting to portray the message
that inflation is not actually going to impact the consumer for too long. Fortunately
for the Feds, people tend to think in 'nominal' rather than 'real' value terms.
For example, investors still feel good buying stocks and bonds of American companies
in U.S. dollars. They don't realize that when measured in terms of gold, or money
unimpeded by fractional banking standards, the S&P has lost some 20 percent over
the past ten years. Over the same period, the U.S. dollar has lost over 280 percent.
Fourth, and perhaps least understood, the massive inflation numbers already created
by the Federal Reserve remains hidden within the banking system. As long as banks
are able to lend directly to the Fed and Treasury at no risk, they have no incentive
to circulate their new dollars. Only when bankers leverage up and lend to industry,
or have their hands forced to do so, as happened in 2004-2005, will the prices of
consumer goods skyrocket, and reveal the already massive shadow-inflationary pressures.
Finally, by changing accounting standards for the banks' toxic assets and making
self-congratulatory pronouncements, the government has created the impression that
the crisis has been averted and that faith has been restored in paper currencies.
This feeling of relief is flawed fundamentally. It will not be long before investors
are brought to the devastating realization that a true recovery from a credit boom
requires tightening and recession - that Washington did not avert catastrophe, but
ensured it, and that the economic expansion that is being called for may still be
a long way off.
As these dynamics unravel, the full consequences of U.S. profligacy are being felt
around the world, as inflationary pressure builds in-line with higher commodity
prices, due in part to the synthetic weakness created in the dollar. Central bankers
could sign any agreement they wish but it won't stem the meteoric rise of gold.
By then, investors will understand that those left holding dollars will be left
holding the bill in the long run.
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