Outlook for the Dollar Price of Gold
By Alasdair Macleod
Now that gold has become overbought on Comex, the price is vulnerable to being trashed, yet again, by the too-big-to-fail banks. It is a familiar operation in gold futures markets, where speculators buying contracts protect themselves with stop-losses.
All the TBTF banks need is a pause in the speculator’s buying and a little good news (bad for gold). Ideally, the active contract will be running into maturity, so the speculators are forced to put up or shut up: in other words, sell the contract, roll it into another later maturity, or stand for delivery.
Bearing in mind these speculators are running highly leveraged positions, greed turns to fear on a sixpence. The TBTF banks will have supplied the speculators with their longs by going short. From the moment you go long, you are trapped in a trader’s version of Hotel California.
The TBTFs start off sitting on losses, not worrying for them, being TBTF. But they know how to turn it around. Just pick a quiet moment, sell a few billions-worth of contracts, and take out all those stops. It is a cycle of events that happens time after time, a money machine for the bullion banks. Just occasionally, it goes wrong, because the physical markets take back control of pricing away from futures markets. But what the heck, these guys will be bailed out by the Fed, or the Bank of England. Meanwhile their traders have made bonuses quarter after quarter.
Speculators fall for it every time. Sooner or later, they argue, the TBTF traders will get their comeuppance. But now that gold has risen $140 in less than two months, we are due for another rinse cycle in the Comex washing machine. Gold is as overbought as it has ever been. The punters are due to be cleaned out again. Only a fool would bet otherwise. But, this time it just might be different.
For this time to be different, the dollar will have to continue to weaken. Not much else can save the bulls from the TBTF bullion banks. This article discusses the prospects for the dollar, and concludes that, other than a technical rally in the short-term, the prospects for the dollar are not good.
There are four fronts opening that could drive the dollar down: the stagnating US economy, oil producer nations discarding the dollar, the interests of China moving towards abandoning the dollar, and lastly, the commercial interests of the major bullion banks shifting towards the China story. We shall consider each in turn.
US economy stagnating
All the hype during President Trump’s first hundred days, when he behaved like a latter-day Franklin Roosevelt in a flurry of initial activity, is being replaced by cold reality. The dollar first rose, and then started to decline. The fiscal benefits of tax reform remain pie in the sky. The stimulus to American industry from tariffs and import duties on imported goods, on second thoughts, is no stimulus, and merely raises the costs faced by consumers. Most of The Donald’s anti-establishment, reforming team has resigned, replaced in the White House by three establishment generals. In a banana republic, the press would call it a military coup. Make America Great Again is now not much more than an empty phrase.
President Trump’s election appears to have set up the dollar for a substantial decline, as this reality sinks in. His policies are being exposed as bombastic and autarkic. By isolating America from the benefits of world trade, she gets almost no benefit from the rapid transformation progressing the Asian continent from economic backwater to economic powerhouse.
Meanwhile, the accumulation of debt is unproductive and a burden on the economy, still financing wasteful government deficits, and inflating consumption. Consumers’ income has failed to keep pace with the cost of living for at least the last two credit cycles. And with the consumer becoming overburdened with a legacy of debt, the economy is struggling, no longer in crisis, but going nowhere.
Those analysts who unwisely think trade protectionism will create American jobs fail to understand that trade deficits arise from a combination of government deficits, the expansion of bank credit, and low savings. Yet these are the policies the government and the Fed are actively pushing for economic recovery. Consequently, the budget deficit next fiscal year is likely to be another $500bn, which we can add to the running total.
For the dollar’s prospects, the most important thing to know is that since 1980 the accumulated deficit on the balance of payments, of which the balance of trade is the major component, will have totalled over $11 trillion by the end of this year. The accumulated balance of payments deficit serves as an indication of the scale of foreign ownership of dollars, only $4.36 trillion of which is identified in central bank reserves around the world. Much of the balance of foreign-owned dollars is owned by businesses, engaged in global trade.
The management of dollar balances is crucial for these businesses’ profitability. They will have noted that on a trade-weighted basis the dollar peaked in January, and since then has lost 7.5%. That is a severe impact on profits. They will be on the alert for further signs of weakness, and will have noted the improving trade prospects for Europe and the Eurozone, which have driven the euro up against the dollar by 15% this year. Furthermore, the Eurozone is running a trade surplus of an estimated €200bn for 2017, leading to an underlying contraction of euros in foreign ownership. The Chinese renminbi (or yuan), has risen 7.3% against the dollar this year, affecting corporations trading with China. Most importantly, it affects oil producers selling into their largest single market. They will be watching the dollar’s progress from here.
There is little doubt that the non-US world owns substantial quantities of the dollar, and can be spooked into selling. For this reason, the poor relative performance of the US economy compared with the more dynamic performances of China, Japan and Europe places the dollar at a severe long-term disadvantage on the foreign exchanges.
Oil producers moving away from USD
The pact between Nixon and Saudi Arabia back in 1973 set the dollar up as the exclusive settlement currency for oil exports, following the collapse of the Bretton Woods Agreement in 1971. Since then, the very few countries that threatened to sell oil for other currencies, notably Iraq under Saddam Hussein, and Libya under Colonel Gaddafi, have met with unfortunate accidents. The only countries to successfully challenge the dollar’s oil hegemony have been Russia, China and Iran, but not without adverse consequences. And now, Venezuela is ditching US Imperialism by selling her oil for a range of currencies, excluding US dollars.
Perhaps Venezuela hasn’t been listening. The experiences of Iraq and Libya sent a clear message to other countries about the consequences of denying dollar hegemony. In the case of Iran, the Americans even leant on SWIFT through the EU, the supposedly independent interbank settlement system, to freeze out all transfers involving Iran in 2012. Iran’s currency all but collapsed under this pressure. But tactics of this sort create more resentment than anything else, and have undermined goodwill among non-aligned countries. The Russians, powerful enough to survive America’s financial wrecking tactics, have now set up their own rival to SWIFT, as well as other moves to make them entirely independent of the dollar.
Increasingly, the Russians and Chinese, as well as the Shanghai Cooperation Organisation which they lead, are encouraging oil producers to sell oil for consumption in Asia for Asian currencies, principally the yuan. To achieve this objective China is developing capital markets to improve the yuan’s liquidity and acceptance as a trade medium. However, she knows that she must offer something more than an alternative to the dollar than the yuan, with its shorter and less certain track record. And this is where physical gold comes in, sound money that is no government’s liability, universally recognised as such even by those that publicly deny its monetary credentials.
China long knew gold would be central to her geopolitical strategy as well as her own long-term security. In the last few years, she has dominated physical markets. She is the largest gold mining nation by far. There can be no doubt she has accumulated substantial undeclared gold reserves since 1983, when the central bank was first appointed for this purpose. She is on the verge of offering oil producers the facility in the Shanghai futures markets to swap oil for yuan and yuan for gold, sourced from outside China. There can be little doubt that oil producers will see this as an attractive alternative to the dollar. Russia and Iran are already signed up. Other countries, such as Venezuela, heavily dependent on Chinese oil demand, appear to be in the process of doing so. But the real prize will be Saudi Arabia.
Saudi Arabia needs money, and if Western capital markets do not provide it in return for a minority stake in Aramco, there’s little doubt the Chinese will strike a deal. The policy of turning the world’s oil suppliers away from the dollar and in favour of the yuan for exports to China has made significant progress in recent months. The next key development will be the full implementation of a yuan futures contract for oil, and that could be introduced in the coming months. When that happens, the dollar’s function as the sole reserve currency will effectively cease.
China’s foreign reserves
China has accumulated a large pile of foreign reserves, the equivalent of $3 trillion. This accumulation, perhaps over $2 trillion of it in dollars, is the consequence of past currency management, the objective having been to enhance the profits of Chinese-based manufacturers exporting to other countries. The early development of the Chinese economy was just an initial phase that encouraged strong flows of inward investment followed by net exports. Furthermore, the Chinese are avid savers, putting aside as much as 40% of their earnings, leading to large and persistent trade surpluses.
On the ground, Chinese economic success has brought substantial improvements to the lives of China’s population. The economy is now being refocused towards services and technology, maturing from its export-led model into a fully-fledged advanced economy with a rising middle class. Furthermore, China has a requirement for enormous quantities of raw materials to satisfy her infrastructure plans, which encompass the whole of Asia.
The need for holding large quantities of dollars, the result of neutralising capital inflows and then suppressing the yuan for export price competitiveness, has now passed. China requires far more modest dollar balances, so she will almost certainly invest them in stockpiles of base metals and the raw materials required for the future. This change in policy is already evidenced by the yuan rising against the dollar by over 7% this year, cheapening commodity imports by this amount compared with dollar prices.
There can therefore be little doubt that China will be a big seller of dollars in future. Her problem is if she is too aggressive in this policy, she will trigger selling by other Asian central banks, and could even risk having her $1.1 trillion holdings of US Treasuries frozen by the US Government. She must tread carefully, unless it suits her to become more aggressive in an escalating financial war. Her policy therefore, is likely to be a seller of dollars into strength rather than weakness. The consequence for the dollar is any price recovery is likely to be capped, and therefore limited in scale and duration.
The banks are changing allegiance.
The major global banks are being forced to refocus their activities towards China and her Asian strategy. Infrastructure development needs financing, and this is being coordinated through the Asian Infrastructure Development Bank. China is internationalising her own capital markets through Hong Kong and London. America is deliberately excluded from these activities.
This does not mean that China is against American banks. Her objective is to do business with all foreign banks competitively so long as it does not involve dollars. This leaves the American banks with a decision: do they go with President Trump’s mantra of making America great again and desist from helping China, or do they do their commercial duty for the benefit of their shareholders, and seek to profit from China’s anti-dollar strategy?
Nowhere is this conflict more acute than in the market for gold and silver. Now that China controls both these physical markets, the major bullion banks have no option but to join the Shanghai International Gold and the International Futures Exchanges. Soon, they will no longer be driving prices down on Comex, predominantly as bears supplying paper contracts to speculating buyers. Instead, they will have to become buyers of physical bullion to deliver to the Shanghai physical and futures markets. It is early days, but already ANZ Bank, UBS, BNP Paribas, Standard Chartered, HSBC, JP Morgan (London Branch) and Goldman Sachs are among the leading banks that have made or are making this transition.
There are large quantities of dollars ready to flow away from foreign ownership, a legacy of the days when businesses were unquestioningly happy to hold them as the principal reserve and trade currency. There has been little alternative until now. Furthermore, China’s central bank probably owns half of all the world’s central banks’ dollar reserves, and it is now in her interests to reduce that exposure.
America is isolated from the global economic growth story, which is centred on China and the Chinese-led development of Asia. America’s abuse of her dollar privilege over the years has left a legacy of mistrust in the non-aligned countries, and these countries are now driving the world’s economic progress. At the Asian economic feast hosted by China and Russia, the only guest not invited is America.
America’s poor state finances and her reliance on monetary stimulus will ensure a continuing supply of dollars to the foreign exchanges through persistent trade deficits. The Trump presidency looks like being a disaster for the dollar, and as soon as this becomes apparent in the foreign exchanges, selling is likely to escalate. And as the dollar slides, it should begin to lose its status as the settlement currency for increasing numbers of oil exporting nations.
The final curtain on the Make America Great Again mantra will be the growing covert support for the Chinese opportunity from major international banks, driven by commercial reality. They simply cannot afford to stand by, and there are early indications of JPMorgan and Goldman Sachs positioning themselves to be physical traders and suppliers of bullion in Shanghai. It would be a surprise if more Western bullion banks do not follow their lead.
Whether this is the time physical gold demand begins to take over pricing leadership from futures markets, only time will tell. But there can be no doubt that the balance of interests for China is turning to now see a weakening dollar. However, China is surely aware of the disruption she will cause in Western dollar-centric markets if she precipitates significant dollar weakness, and therefore strength in the gold price. She will not want to be blamed for overtly triggering the dollar’s demise as a reserve currency, which probably explains why she has deferred the launch of the yuan-for-oil contract, and is proceeding cautiously.
Obviously, geopolitics plays a central role in timing, with America desperate to oppose China in partnership with Russia as the dominant state on the Eurasian continent. The consequences of ending America’s financial hegemony are not to be underestimated, and China will not take such a step lightly. However, investors in Western financial markets appear to be beginning to get the message that the heyday of the dollar is now over, there is a significant decline ahead, and therefore mainstream investing institutions need to reconsider their asset allocations in favour of physical gold at the expense of the dollar.
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