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Gold is the Answer to Currency Wars

Commodities / Gold and Silver 2012 Feb 13, 2012 - 03:15 PM GMT

By: Eric_McWhinnie

Commodities Best Financial Markets Analysis ArticleCurrency Wars: The Making of the Next Global Crisis is a national bestseller that discusses the serious financial threats facing the U.S. dollar.  Readers will discover that currency wars have happened before and they always end badly.  The U.S. dollar is currently at the center of a new currency war, which threatens its very existence.

Author James Rickards offers valuable insight to readers through more than 30 years of experience in global capital markets.  He is Senior Managing Director of Tangent Capital Partners, a merchant bank based in New York specializing in alternative asset management solutions.  He has also held senior executive positions at Citibank, RBS Greenwich, Long-Term Capital Management and Caxton Associates.

I recently had the pleasure to speak with Mr. Rickards about his new book and the assault taking place on the U.S. dollar.

Eric McWhinnie: What is the key take away from your new book?

Mr. Rickards: You can not take the dollar for granted.  I think there is a sense among many of the policy makers and Federal Reserve board governors that the dollar will always be the key reserve currency, and there is no good alternative.  Therefore, you can borrow or print as much as you want and have as much debt as you desire.  The thinking is that we will eventually grow and pay it back, or there will be inflation or some other remedy.  The belief that the dollar is a punching bag that will never break is incorrect.  We need to be more conservative or we risk a general collapse of confidence in the dollar.

Eric McWhinnie: Do you think the Fed’s Operation Twist could be used by the Chinese to harm the U.S. dollar?

Mr. Rickards: One of the most widely discussed areas of financial confrontation involves the Chinese holdings of Treasury debt.  The Chinese have overwhelming chosen to park reserves into U.S. dollar denominated instruments. The vast majority of reserves are in U.S. Treasury obligations.  They have over $2 trillion of these, and their total reserve position is about $3 trillion equivalent.  It is often suggested that if Chinese wanted to do massive harm to the U.S., they could dump all their bonds and cause interest rates to increase.  This would cause damaging and catastrophic effects to the housing market, stocks and unemployment.

This is extremely unlikely to play out for two reasons.  First, which I personally do not put much weight on, the Chinese would be shooting themselves in the foot as the price of their remaining bonds would be dragged down by selling a large portion of the bonds.  If you sell 10 percent of your portfolio, you might move the price adversely on the entire 100 percent and incur massive losses.  This reason is technically true, but this just might be the cost of inflicting harm on your enemies. It is not as if aircraft carriers or missile forces are free.  Incurring trading losses on a bond account may or may not be worthwhile.

The better and more powerful answer in my view, to as why this bond dumping would not take place, is that the President of the United States has emergency economic powers to stop the Chinese in their tracks.  All Treasury obligations today are in electronic book entry form, as opposed to bearer paper form.  All the government bonds and money moved and cleared through the banks go through a system called Fedwire, which is controlled by the Fed.  The Treasury and the Fed together control the choke points for dollar transactions worldwide and U.S. government security transactions.  If the Chinese started dumping bonds, all it would take is one phone call from the President to the Treasury to freeze the bond accounts.

There is one variation to that.  China could say fine, we are not going to dump anything.  But with Treasury securities maturing all the time, the Chinese have reinvestment decisions.  They could choose to reinvest in 30-day, 90-day or 1-year Treasury bills, and shorten their maturity structure.  This would cause much less exposure to volatility and increase liquidity.  It is like shortening the fuse on the time bomb. I think the Chinese are in fact pursing that path and reducing their exposure to the U.S. by shortening the maturities.  As far as Operation Twist is concerned, it does not really affect the Chinese one way or another.  At the margin, it does improve the pricing and makes it a little bit easier to do, but it won’t really affect their ability to do it.

Eric McWhinnie: How does the Fed’s recent decision to keep interest rates at record lows until 2014 play into currency wars?

Mr. Rickards: This is the main weapon in currency wars.  The quantitative easing programs, including QE1, QE2 and soon to be QE3, and the Fed’s zero interest rate policy are all part of currency wars.  The Fed wants to cheapen the dollar, plain and simple.  They won’t come out and say that, but that is the policy.  The reasons for this are straightforward. The Treasury, Fed and White House believe a cheap dollar will help U.S. exports by making our goods less expensive to people who buy them from abroad.  That will promote exports and help GDP and economic growth, leading to a creation of jobs at U.S. factories to satisfy demand.  It all sounds really good, but the problem is it never works.  The U.S. does not operate in a vacuum, there is always some push back or retaliation when we try to cheapen our currency.  Other countries also try to cheapen their currency, which is the nature of currency wars.  This can quickly lead to trade wars and a replay of the 1930s.  People often say the Fed is out of bullets with zero interest rates, but this is untrue.  The Fed still has quantitative easing to cheapen the dollar.

Eric McWhinnie: Do you think central bank gold purchases will continue, and do you think it is a contrarian indicator?

Mr. Rickards: I do think central banks will continue to purchase gold.  Investors need to separate the Fed from other central banks.  The Fed got many things wrong and I do not think the Fed understands the statistical properties at risk. I also think they have done a lousy job as regulators and their economical forecasting skills are minimal.  But the Fed is not the central bank buying gold.  Asian and Russian central banks tend to be the ones buying gold as they do not hold enough relative to the size of their economies and paper money supply. For all its faults, the U.S. has 8,000 tons of gold.  China, which has an economy almost half our size and a money supply larger than ours, only has officially a little over 1,000 tons of gold.  They have a fraction of our gold for an economy half as large.  Clearly, the U.S. is a gold giant while China is a gold pigmy.

If I were China, I would be buying all the gold as fast as I could.  The problem comes with the market impact of the strong demand.  You want to operate by stealth to avoid bidding up the price.  You should operate by using agents, banks and other intermediaries to buy the gold for you so the market does not know it is you.  It is a delicate game, and I do not blame the Chinese for playing it like they do.  I think the central bank buying is not a contrarian indicator, but a very bullish indicator.  The people who are buying are the people who do not have enough gold to begin with.  They are trying desperately to increase their gold reserves to support the paper money supply.  This tells me they think at some point the paper money system will break down.

Eric McWhinnie: What are some ways for investors to protect themselves?

Mr. Rickards: I recommend that every portfolio should have some gold in it, mainly as an inflation hedge and also as an attractive investment.  For the conservative client I recommend a 10 percent allocation, and 20 percent for the aggressive client.  I do not like the idea of putting a large amount of a portfolio into a single asset.  If I am right about gold, and I expect I will be, the returns on that 10 percent or 20 percent will help preserve wealth.  Bullion coins from the U.S. Mint such as an American Gold Eagle are also an excellent way to hold gold.  You do not want to buy antique or collectible coins, gold is gold.  The premiums that come with these coins are not worth it.  American Gold Eagle coins are reliable, high quality and a reasonably priced way to hold gold.

More insight from James G. Rickards can be found on Twitter @JamesGRickards.

For more analysis on our support levels and ranges for gold and silver, consider a free 14-day trial to our acclaimed Gold & Silver Investment Newsletter.

By Eric_McWhinnie

Wall St. Cheat Sheet : Only days after the S&P 500 crashed to the depths of hell at 666, the Hoffman brothers launched Wall St. Cheat Sheet: one of the fastest growing financial media sites on the web. Like a samurai, our mission is to cut through the bull and bear shit with extraordinary insights, a fresh voice, and razor-sharp wit. We provide the highest quality education and information for active investors, financial professionals, and entrepreneurs.

© 2012 Copyright Eric McWhinnie - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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