Stealth Rally in Gold Prices Enabled by the battered US Dollar
We are now officially on board a train which is gathering speed towards its buffers: the end of dollar hegemony and its potential collapse. It might take a few years yet to get there, but the speed of our train is dependent to a large degree to how the engine’s boiler is stoked by America through her isolationist plans. It is very hard to see how the dollar cannot decline significantly with America’s autarkic trade policies, benefiting gold prices.
The erosion of the dollar’s petrodollar status
In all currency pairs, international traders have to take into account factors driving two currencies in assessing a future exchange rate. The purpose of foreign exchange at its most basic is to settle gross cross-border trade movements, with the balance of these flows paramount in determining the exchange rate. Today, by far the largest trading nation is China, so settling trade between the dollar as the default currency for trade and the yuan is the most important currency issue today.
China manages her currency rate to her perceived national advantage. In recent years, this has meant tracking industrial commodity prices. When they were falling measured in dollars, the yuan was managed lower with them. But with commodity prices rising from last January, the yuan has also risen. We can therefore assume that as China’s imports of commodities accelerate to satisfy the ambitions of her current thirteenth five-year plan, the yuan will continue to be managed to rise in line with the general level of commodity prices.
From this flows the relationship between the yuan and the dollar. That said, China manages to keep commodity prices suppressed through the simple expedient of bypassing markets by purchasing agreements that only use market prices for reference. Doubtless, China hopes that through off-market supply agreements, her infrastructure plans will not raise commodity prices unduly against her.
This hoped-for period of relative calm in international commodity markets should allow China to pursue her plans to increasingly use yuan for trade settlement with her energy and commodity suppliers. She has already set up some of the financial instruments to make the yuan more acceptable to suppliers, and held back on others, notably energy. The oil-yuan futures contract has been the subject of considerable controversy, because it will allow oil suppliers such as Iran to bypass the dollar entirely and to hedge yuan by buying gold through matching yuan-gold futures.
For the avoidance of doubt, these contracts are only available to non-domestic traders, and any gold bullion acquired through the yuan-gold futures contracts will be sourced from international markets, not China nor her citizens.
The problem with these contracts is they amount to a frontal attack on the US-dominated international financial system. Since the collapse of the Bretton Woods Agreement in 1971, the Americans have rejected all monetary roles for gold, and selling commodities or goods for gold is strongly discouraged. More sensitively, pricing and selling oil in anything other than the dollar is a direct threat to the petrodollar and the dollar’s hegemony. For these reasons, the Chinese have held back on plans to introduce an oil-yuan futures contract, though the exchange is set up and ready to go.
It is quite likely the subject of these contracts has been discussed between Beijing and Washington, given their sensitivity. However, if the Chinese don’t introduce oil-for-yuan futures soon, it is likely other exchanges might, given the potential demand and China’s preference for settling energy purchases in yuan. There already exists a yuan-for-gold future in Dubai, and it would make enormous sense to introduce a matching oil-for-yuan future alongside it.
The largest oil exporters by volume to China are Russia, followed by Saudi Arabia. Both Russia and Angola, another major supplier, are selling oil for yuan. Saudi Arabia will need to do the same, to maintain market share, and there are rumours this will happen early in the new year.[vi] Saudi Arabia is tiptoeing cautiously towards China and Russia, recognising that is where her commercial future lies. However, it was the agreement between Nixon and King Faisal in 1973, which created the petrodollar and ensured all other commodities would continue to be priced in dollars after the Nixon shock. If the Saudis start accepting yuan for oil, it will mark the end of that agreement and therefore the beginning of the end for the petrodollar. At that point, the oil-for-yuan futures contract becomes inevitable, if not already introduced beforehand.
Applying the brakes on the speed of change is never easy, and if the market wants something, someone, somewhere, will provide it. This is the reality behind the oil-for-yuan issue. Elsewhere, China’s plans move on. Financing structures for Asian infrastructure spending are being assembled. For example, a private £750m fund, chaired by ex-Prime Minister David Cameron, was announced this week and it will act as a lead manager for UK and European based infrastructure investments in Silk Road and other Asian Infrastructure Investment Bank projects. This will help ensure the City of London continues to play a major international financial role after Brexit.
These developments will undoubtedly be a major blow for the dollar in 2018, adding to selling pressure on the exchanges. Once these pressures become more apparent, foreign owners of dollar investments are bound to become nervous, being over-weighted, holding $17.139 trillion in mid-2016, the last date of record.
Global interest rate outlook, and the implications for gold
In 2018, major economies can expect to run into a brief expansionary phase of the credit cycle before the next credit crisis. By the expansionary phase, we mean the reallocation of credit from financial assets to non-financial activities, which will be recorded as a further fall in bond prices, the beginnings of an equity bear market, and a material acceleration in nominal GDP.
This phase happens in every credit cycle, when returns on financial investments decline and risks in non-financial lending appear to have receded, along with memories of the last credit crisis. When extra bank credit is then applied to non-financial demand and supply, prices of goods and services inevitably begin to rise as that credit is spent and the price effect spreads through the economy. In some nations, this process has been evident for some time. Given these things develop a momentum of their own, it is likely that in 2018 prices of raw materials will resume their upwards trajectory, and price inflation in fiat currencies will rise as well.
Fueling this trend will be China, whose appetite for industrial commodities is planned to escalate significantly. This is why China is likely to offset some price inflation pressures through managing the yuan’s exchange rate upwards against the dollar. While China’s commodity purchases will predominantly bypass markets (as stated earlier in this article), there can be little doubt major shortages will develop as other economies, benefiting indirectly from China’s expansion, increase their demand for raw materials. A combination of rising goods and services prices will be coupled with falling bond and equity prices, as the reallocation of bank credit from financial activities gathers pace. Central banks will desperately try to moderately adjust interest rates upwards, hoping not to trigger a credit crisis. The result is they will always be one step behind the markets, and these are the optimum conditions which favor gold.
Driving the global economy, is of course, China. Without China, other major economies would stagnate, with ordinary people heavily encumbered by a triple burden of taxes, regulation, and wealth destruction through monetary inflation. It stands to reason that those closest to the Asian story benefit most. Commodity suppliers, led by Russia, the Central Asian states, Australasia, the Middle east, sub-Saharan Africa and Latin America all benefit from China’s thirteenth five-year plan. Canada does as well. Europe benefits from increased trade through the Silk Road, where goods are now in transit for less than two weeks compared with a month by sea, a time that will soon be cut to less than ten days.
The observant reader will notice the United States is missing from this list. America has moved from being the world’s dominant economic power, to only supplying the commonly used currency, a currency that is rapidly becoming irrelevant for trade. By pursuing an isolationist “America first” policy that restricts free trade, America will end up last.
For this reason alone, the bearish headwinds facing the dollar and an isolated US economy in 2018 appear to be badly underestimated.
The Year for Gold
On domestic and international considerations, the outlook for the dollar is deeply negative, and so is correspondingly positive for the dollar price of gold. Price inflation in the US will likely increase, and the Fed, fearful for bond markets and asset prices generally, will be too slow in its response. In any event, raising interest rates does not restrict the money quantity, which according to monetarist thinking is what will be required to bring price inflation under control.
Instead, rising interest rates alters the allocation ratios between cash and term loans. Eventually, central banks raising interest rates will trigger the next credit crisis, but until that happens, the dollar is likely to be weak against commodity prices in particular, and the yuan as well, assuming the Chinese authorities continue to track commodity prices in their currency management strategy.
Internationally, portfolios are loaded to the gunwales with dollars, a remnant of past dollar strength, so they are quite likely to turn sellers. Meanwhile, the largest trading nation by far, China, is doing away with the dollar, and is fully aware that this policy could easily end in a disaster for the world’s reserve currency. Presumably, the Chinese anticipated this eventuality when they began to accumulate gold from 1983 onwards, and encouraged their citizens to do so as well after 2002. Owning physical gold is the ultimate protection against a fiat currency collapse.
Next year is almost certain to see the introduction of hedging facilities for oil exporters to China, forced to take yuan for oil. An oil-for-yuan contract is ready for launch, and could easily be announced in the coming weeks. This event, which is increasingly inevitable, will mark the end of the petrodollar, and can be expected to begin a major financial upheaval, likely to spread to all commodity markets.
Meanwhile, the Americans seem oblivious to these challenges. Only this week President Trump in his National Security Strategy document again promoted his trade isolationist policies, while maintaining that America still has primacy over other nations. This is wholly delusional, because the economic locomotive pulling the world along is China, not America.
The cryptocurrency phenomenon, if it continues, is likely to be an additional destabilising factor for the dollar. In truth, bitcoin and the dollar share the same lack of true monetary status, but their supply characteristics are where they differ. Cryptocurrencies seem likely to expose fiat currencies’ weaknesses, which after all is why they come into existence.
This background of negative events for the dollar is also the primary positive factor for gold. For years, control of the gold price has been suppressed in American markets, through the expansion of unbacked gold derivatives. That control is likely to be first challenged by a weakening dollar, and ultimately wrested from US futures and London’s forward markets, if only because physical gold markets are now firmly under Chinese control. –
Keep Watching The US Dollar In 2018
After a major downside surprise in 2017, one of the biggest stories for 2018 will be the relative value change in the US dollar.
We say “relative value change” because, of course, the US dollar is typically measured by changes to the US Dollar Index. This index compares the value of the dollar to a basket of other major fiat currencies. So when we say, “the dollar is falling”, what we’re really saying is that it is depreciating versus the euro, yen, pound and others. See below:
2017 began with the general consensus that the US dollar would strongly rise in the months ahead. Almost all Wall Street economists predicted this, and it led the venerable “Economist” magazine to print this cover in late 2016:
Well, a funny thing happened on the way to a dollar resurgence. . . . The index actually fell …and, in fact, it fell quite sharply. It seems that though The Economist believed a dollar rise was coming, Janet Yellen and President Trump said otherwise.
And now here we are again at the start of a new year …and, once again, predictions of “dollar strength” abound. But is that about to play out? The chart below from the first trading day of 2018 appears to disagree. Note the breakdown below 92 with what appears to be a test of the 2017 lows near 91 coming very soon:
For further clues, check what the CRB Commodity Index is telling us. Any breakout about 195 would be significant:
More specifically, what is copper saying about the future of the US dollar? Ole DrC is now at multi-year highs and at levels not seen since July of 2014. And where was the US Dollar Index trading back then? Close to 80!
So let’s be sure to watch the US dollar very closely in the months ahead. If it falls another 10% or more in 2018, what will that mean for gold, silver and commodity prices, in general? And with so many prices already on the verge of significant breakouts, the surprise of a falling dollar may be the fuel to prompt renewed bull markets across the board. – Craig Hemke
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