April 6,2008

April 6, 2008
Outlook for the US Dollar and Gold

The outlook for Gold should never be considered independently of the outlook for the US Dollar and the many determinants that can affect the latter. Accordingly, in this report the US Dollar (USD) will be considered first with emphasis on the high levels of exchange rates recently reached by the currencies of our major European trading partners since these currencies are the ones that affect most the widely used Dx Index.

The most common fallacy in the evaluation of currencies and exchange rates is to consider only their absolute values, Over over long spans of time, however, these values cease to be comparable. For instance, due to many factors, a value of 80 for the Dx is not the same as the same value in 1990. The best way to correct for this deficiency is to consider current exchange rates in relation to some kind of common denominator or standard that could give a true measure of changes over time.The Purchasing Power Parity (PPP) has been the most widely measure used in this regard and has been routinely used in this site. In an earlier report on the EURO, for example, it was pointed out that, while the EURO had reached all time high levels against the USD, when measured in terms of PPP it was still far below the peaks seen in the early 90s.
 (see: PERSPECTIVE ON THE US DOLLAR (USD) AND THE US DOLLAR INDEX).

This situation is still true today not only for the EURO but also for the British Pound, the Swiss Franc, and even for the Canadian Dollar in spite of its recent huge run up. In this context, it is wrong to state that the USD has fallen to all time lows against the EURO an other European currencies. Likewise, since these currencies contribute most of the weight in the composition of the Dx Index, it is wrong to state that the USD has fallen to historically low levels. In other words, the DX can be said to badly overstate the weakness of the USD, The three charts of the EURO, British Pound, and Swiss Franc presented below, include both the exchange rates and the percent deviations from their PPPs. It can be readily seen that the relative rates of all three currencies in term of percemtages above their PPPs have yet to surpass the highs seen in the early 90s.

The next important point to note in examining the charts is that, while these currencies have not attained yet the highs of the 90s, they have come close to doing so before their recent rollover. In fact, it is astonishing that at their recent high both the EURO and Swiss Franc reached almost exactly the percent level above PPP that they attained at their peak in 1990. This is significant because of the many parallels noted between the current recession and that of 1990 (see:
The scenario for a possible stock market bottom:1990 recession re-visited again) when the last quarter of that year saw the bottom of the USD, the bottom of the stock market, and the middle point of the economic recession.

It is obvious that the peak seen in 1990 represented an inflection point for the currencies and the USD. Such inflection points, often followed by trend changes, are to be expected when deviations from PPPs become so extreme that they can no longer be sustained. This is because under these conditions US exports are significantly boosted, trade deficits improve, and demand for US Dollars increases causing a self-correcting mechanism that will tend to bring the currencies back down to their PPPs levels. Indeed, such improvements have aleady begun to occur in this economic cycle at the present time.

From these considerations, it is reasonable to expect that European currencies are now at, or may be soon approaching, an inflexion point similar to that of 1990, and if so, that the USD may be at, or close to, a bottom. This doesn’t mean that it would be ready to embark on a strong rally. Several factors, including economic growth and interest rates differentials and a Fed still locked in a long phase of monetary easing, will remain as strong head winds against its strong rise. Therefore, the most likely outcome is that the USD will graze the bottom for a prolonged period of time.

The implications of these conditions for Gold are clear.If the USD won’t continue to decline, Gold  won’t continue rise and, as long as the USD grazes the bottom, Gold prices will remain locked in the recent range of $850-1,030.