The United States is incomparably the stronger defense power; indeed the U.S. is now the only defense superpower in the world. As Britain found at the height of imperial power, it is not always easy to convert defense capacity into financial strength. Nevertheless, it was the sails of the British navy that maintained world peace in the nineteenth century and made the gold standard possible.

In 1797 the Napoleonic War led to the suspension of gold convertibility, which was not resumed until after the Battle of Waterloo in 1815. Gold convertibility was again suspended in 1914, on the outbreak of the First World War. Britain was able to maintain gold convertibility for the hundred years of relative peace, which allowed the industrial revolution to spread around the world. In the 1860s, the United States had to suspend gold convertibility, during and immediately after the Civil War. The euro is now protected by U.S. defense capacity.

A more immediate concern is the growing divergence of European economies. Two big European economies, Italy and Spain, are perceived as more risky than the two core members of the Eurozone, Germany and France.

The traditional indicators of risk in debt markets, as reported in The Financial Times, are Credit Default Swaps (CDS) and 10-year bond yields. The 10-year bonds are particularly interesting as they are Eurobonds for which the different Euro countries are separately responsible. Currently the Italian 10-year bond yields about 60 basis points more than the German, which is the benchmark bond. Greek bonds also have high yields.

Financially, Europe can be divided into two zones. The Southern zone includes Italy, Spain, Greece and Portugal, of which only Portugal is not a Mediterranean country. Ireland is also financially overexposed, but Ireland is a small economy, and has separate problems over the Lisbon Treaty.

The Northern group of the Eurozone countries are the Franco-German alliance, which includes the adjoining three core countries of the original six nations of the Rome Treaty — Belgium, the Netherlands and Luxembourg. On present financial trends, there are three Europes, a Mediterranean Europe, led by Italy, a core Franco-German Europe and a peripheral Europe, in which Britain is the largest economy. The peripheral Europe includes Scandinavia, the Central European group and potentially, a Balkan group.

In American history, the original division was between North and South. That would now include the West as a separate economic zone. Europe is already divided in three ways. The risk is that North and South Europe will diverge in economic capacity. Can Italy or Spain maintain a fixed exchange relationship with Germany? The stronger the euro becomes, the greater the internal strains on the Eurozone are likely to become.

Regards,
Lord William Rees-Mogg
July 24, 2008

Problems with the Euro was originally featured on Whiskey and Gunpowder

Gold isn’t the only commodity on a tear. Gold’s little brother silver has surpassed the $20 per ounce level, oil hit $110 per barrel, natural gas is above $10, soybeans traded as high as $16, and wheat surpassed $20 per bushel. The currencies have been on a tear, as well, the most noteworthy being the yen, trading in the 100 handle, and the euro, trading as high as $1.56.

Supply and demand fundamentals, as well as the commodities supercycle, have affected many of these markets, but when you have a move across the board as we have, must look at the other side of the equation. I am, obviously, talking about the falling dollar.

Investing in any one of these commodities is a fine way to hedge the falling dollar, and investing in a broad array of these commodities is even better. But I would like to use this post to discuss the two most common dollar hedges.

I was recently contacted by a friend who is in Germany on an extended stay. He is set to return to the U.S. in a couple of months. The reason he e-mailed me was to inform me that he has been accumulating euros as a hedge against the falling dollar. We opened up a dialogue comparing euros and gold as dollar hedges in the past and going forward.

The obvious reason you would buy euros or gold is because you are short the dollar. I don’t need to state that we agree with that position. As a reader of Whiskey & Gunpowder, you know our view on the systematic destruction of the U.S. dollar by the Federal Reserve.

So let’s start off by looking at the past performances of the euro and gold versus the U.S. dollar, starting in 2001. The reason I chose 2001 is because that is when the most recent bear market for the dollar began. For obvious reasons, this approximately coincides with the bottoming of the euro and gold markets.

In 2001, approximately 95 cents bought you one euro. Today, it will take $1.56 to buy one euro. So if you had bought euros in 2001, you would have had a cumulative return of 64 percent.

How about gold? If you had bought an ounce of gold in 2001, you would have paid approximately $260. With gold hitting $1,000 per ounce, you would have made a cumulative return of 285 percent.

So the question of which dollar hedge has been the most effective thus far is a no-brainer. Gold has significantly outperformed the euro over the past six-plus years. In order to pursue this question further and make some predictions going forward, we need to ask ourselves why gold has outperformed the euro as a dollar hedge.

I believe the reason is very simple. The euro, just like the dollar, is a fiat currency. It is not backed by a gold or silver standard, therefore leaving the value of the currency up to the good, or not-so-good, nature of the monetary authority. If history has shown us one thing, it is that central banks are good at devaluing currencies. The reason the euro has appreciated against the dollar is because the Fed is inflating much faster than the ECB. So more or less, the 64 percent gain is equal to the cumulative inflation of the money supply of the dollar minus the cumulative inflation of the money supply of the euro.

Gold is a different story. Although global monetary authorities, including the IMF and BIS, have attempted manipulation of the gold markets, the real effect in the long run is essentially zero. Simply put, gold is probably the only asset left in the world that is no one else’s liability. There is one thing we can look at. The closest thing in the gold market that compares with the inflation of the euro is gold mined out of the ground. Because of the commodities supercycle and changing financial tendencies, growth in global demand for gold has grossly outstripped newly mined gold and gold sold by central banks. So for lack of a better word, gold supply is deflating.

So the euro has appreciated against the dollar, but it has been inflated in its own right, while at the same time, it is impossible to inflate gold. The best way to sum this up is to look at the price of gold in euros. You will see that gold priced in euros has increased by 133 percent since 2001. The price of gold is as good a judge of inflation as any. So theoretically, the difference in inflation between the euro and the dollar should approximately equal the difference in price increase between gold valued in euros and gold valued in dollars. That difference is actually 153 percent, which doesn’t exactly equal the 64 percent appreciation of the euro against the dollar.

So where does the additional 89 percent come from? It’s hard to say. It could easily be attributed to the fact that the euro was still a very young currency, it could be because of the commodity supercycle, or it could be due to some other reason. This is not a question that I have looked very deeply into. Regardless, it does not affect the analysis of the past, present, or future relationship between the dollar, euro, and gold.

Moving on, the final aspect of this piece is to figure out what the future will bring for the two most popular dollar hedges. The question we have to ask ourselves is will the trend change? Will gold be the best dollar hedge going forward? The simple answer to that question is no, but there never really seems to be a simple answer.

So to restate my answer, over the next couple of years, gold will continue to be the best hedge against a falling dollar. In fact, I expect gold to outperform the euro more significantly in the near future than it has over the past six years. This view doesn’t have any fundamental basis to it. If the end of the precious metals bull market in the early ‘80s is any foretelling of how the current gold bull will end, we have some fireworks to come. What I mean is that as the Johnny-come-latelys enter the precious metals market, it will exceed its true value and balloon into a bubble that will be remembered for some time to come.

It is at this point that the trend of gold outperforming the euro as an inflation hedge will no longer hold true. The new trend will be the transition into the euro as the new reserve currency of the world — and that is a discussion for a future day.

But for the time being, I strongly recommend owning gold over euros as the best inflation hedge against the dollar. It doesn’t really matter exactly how you do it, whether it be with physical metals, mining stocks, ETFs, futures, or option. It all depends on which investment style suits you best. But the more diversified your portfolio, the better. That is why I recommend owning not only gold, but also a broad array of commodities investments, ranging from the energy sector to agricultural commodities and precious metals…and yes, even some foreign currencies aren’t a bad idea.

Regards,
Nick Jones
March 17, 2008

Dollar Hedge was originally featured on Whiskey and Gunpowder

“Those who oppose reform may get revolution.”

— John F. Kennedy, speaking of Latin America in 1962

THE EURO HIT FRESH ALL-TIME HIGHS VERSUS THE DOLLAR already this month — and we’re only one trading week in.

So might U.S. investors want to switch out of gold bullion ahead of Easter this year and move into the single currency, instead?

After all, the euro still pays 4.0% interest per year — a feat that dumb gold could never promise or achieve — and with eurozone inflation holding at a record 3.2% year on year in February, the European Central Bank (ECB) is clearly in no mood to start slashing rates now.

“Inflation will not slow as markedly as supposed,” warned the ECB’s Axel Weber last week. Colleague Juergen Stark added that he was “highly dissatisfied” with the current surge in the cost of living.

Tight money to come, right? Well, the gold market doesn’t buy it. Not at $1.52 to the dollar — with European manufacturing squeaking and Mediterranean house prices slipping:

The gold price for French, German, and Italian savers just keeps on rising, gaining for six of the last seven months.

Yet luxury carmaker BMW says it can’t bear a further “sustained rise” in the euro above $1.50 to the dollar. Last week, it cut 5,600 jobs.

Dassault Aviation in France says it can’t compete at this kind of exchange rate, either. “The natural step is to shift to the dollar zone [including most of Asia, remember] or low-cost areas as they have done in the car industry,” said CEO and Chairman Charles Edelstenne to Le Monde last week.

“This could include parts of our factory plant and some research tasks.”

Put another way, Europe has got the worst of both worlds right now — a high-value currency that’s crimping exports, and surging inflation at the very same time. So the European Central Bank needs to talk tough while doing nothing, hoping the inflationary and currency pressures don’t squash the economy both at once.

Good thing the old economies retain such political importance, as well. Right?

“To have an increase in the [voting] quotas of emerging countries — China, India, Brazil — is very difficult because the sum has to add up to 100%,” noted Dominique Strauss-Kahn, head of the International Monetary Fund in late February, “so some others must lose.

“The ones who are going to lose are mainly the European countries, and that is the reason why they may be reluctant [to vote for change].”

The debate goes far beyond the IMF, however, that brave remnant of postwar global planning. All top-level political groupings now face the problem of too many powers, with too much at stake, all wanting to be members of the top few spots in the oh-so-crucial club.

The G-7 group of industrialized nations, for instance, currently invites three eurozone nations to the party — Germany, France, and Italy — as well as Canada, Japan, and the United States.

The United Kingdom gets to tag along too, not least because it’s still vying with China for the No. 4 slot in world GDP, behind the U.S., Japan, and Germany. It also prints the world’s No. 3 reserve currency, the British pound. And my, but how it prints it!

Growing by 12.9% in January from a year earlier, the broad supply of pounds sterling has now been expanding at a two-decade record since March 2005.

No wonder the gold price in British pounds is surging alongside the U.K.’s trade and government deficits. But “When are we gonna get the real players, with the money, in the middle of these [G-7] debates?” asks Jack Welch, former head of General Electric. He was talking to Larry Summers, U.S. Treasury secretary at the tail end of the last Clinton presidency, on CNBC last week.

“It seems like some of our government institutions are living the last war — for example, the G-7. Four European economies, Canada, Japan, and you guys [the U.S. Treasury], all meet…but the money’s somewhere else.”

“Oh, you know how these things go, Jack,” replied Summers, former president of Harvard University and now a part-time hedge fund consultant in New York. “It’s much easier to get people in than it is to get other people out…

“You want to have a reasonably small group. We worked with the Canadians to set up the G-20 for exactly the reasons you give. And I think [U.S. Treasury] Secretary Paulson is to be commended for the effort he has put into having a regular financial dialogue with China on a bilateral basis.

“I think you’re going to see this kind of evolution. Look, if we want to address this issue of sovereign wealth funds — which I think is a concern, though it’s a concern that has to be kept in perspective — the way we’re going to do it is by having dialogue with the countries that, just as you say, have the money. Some of them are China, some of them are in the Middle East, and I think we do need to recognize more than we probably have before that the distribution of financial power and influence and capacity is pretty different from the distribution of the sort of political congeniality with U.S. interests across the board.

“That means we may need to have a somewhat different grouping for the foreign ministers and the finance ministers.”

Can political and financial power really be split into two different groups…with the United States at the head of both, choosing its allies here, but inviting a different clique of friends there?

Perhaps with Europe gnashing its teeth about the high euro, it’s actually time for the dollar itself to bounce, rallying from new all-time record lows on its trade-weighted index and forcing U.S. gold prices lower.

Sure — it might require higher interest rates from the Federal Reserve, rather than the campaign of monetary destruction begun by Ben Bernanke back in August. Or conversely, those new record lows in the world value of the U.S. dollar might help stoke U.S. export sales so fast that they revive the major Wall Street stock indexes and erase the last five months of losses.

No?

Should the dollar and Wall Street’s collapse continue, meanwhile, some kind of new monetary world order will only continue to look ever more likely. Russia is preparing to price and sell crude oil in rubles, for example, rather than dollars. The ruble might also be used as one means of payment on a forthcoming Iranian oil exchange in Tehran, according to Iran’s ambassador to Moscow last month.

But whatever comes, and no matter what happens to the price of gold, don’t expect the chocolate bunnies of today’s monetary order to vote for either Easter or a heat wave…let alone both at the same time.

Regards,
Adrian Ash
BullionVault
March 7, 2008

The Dollar’s Continued Fall was originally featured on Whiskey and Gunpowder