GOLD’S RALLY IS WITHOUT FOUNDATION
JANE FOLEY
RESEARCH DIRECTOR, FOREX.COM
A bout of profit taking on Friday barely made a dent in gold’s storming rise last week and other commodities were not lagging far behind. Dollar-denominated commodities were underpinned by the creeping feeling that the desirability of the dollar may now be fading.
Equally supportive was a rise in inflationary fears, despite the fact that there are no concrete signs to suggest any imminent return to inflation. The US dollar may have been wobbling but there are massive political and practical hurdles associated with knocking it off the podium of being a dominant global reserve currency, which should afford the greenback protection for some years yet.
Textbook economics suggest that the US’s persistent deficits in both the budget and current account raise the possibility that the dollar will have to correct lower to help cut the gap. This, understandably, makes US dollar creditor nations rather nervous.
But the mechanisms of the FX market, however, are not as simple as textbooks would have you believe. Diversification away from the US dollar is complicated by the fact that there is no clear alternative candidate for a global reserve currency. The Chinese yuan is not fully convertible and while China’s financial system will evolve over the next couple of decades, this will obviously take time and be a slow process.
Interestingly, recent data suggests that there may have been a slight shift away from the dollar this year. The second quarter was the first time that central banks have accumulated more than $100bn of reserves in just one quarter and only $40bn of this was in US dollars.
UNIFIED CURRENCY
But even if the dollar were to be dropped as the preferred medium for trading oil or other commodities, this would not happen overnight. A newspaper last week wrote about a plot to stop using the dollar in oil trading and replace it with a basket of currencies – one of which was a unified currency from the Gulf region, which does not yet exist. But there is every possibility that in the time taken to launch this new currency, the dollar’s credentials will have improved sufficiently to make speculation of dropping it little use.
But in the meantime, it is in the interest of dollar creditor nations to support the US Treasury’s strong dollar policy sufficiently to prevent the greenback, and consequently the value of their holdings, depreciating significantly or at a rapid pace.
EXCESSIVE INFLATION
On the inflation front, there is no reason to consider this month’s rate hike by the Reserve Bank of Australia (RBA) as a warning of excessive inflation in the longer run. The decision by the RBA will have no bearing on the decisions taken by other central banks – Australia’s circumstances are very different to that of the G3 because it has avoided technical recession completely, only experiencing one quarter of output contraction.
Granted, ever since the issue of quantitative easing (QE) was first placed on the table by the Fed, the Bank of England and others there have been fears that inflation would raise its ugly head during the next two to three years.
However, following the introduction of QE, inflation data has not produced any of the fears that had been predicted. The Bloomberg survey puts the US consumer prices index (CPI) at a moderate 1.9 per cent year-on-year at the end of 2011, up from an expected annual -0.5 per cent year-on-year. UK inflation CPI has been fairly sticky but at 1.6 per cent year-on-year it is comfortably below the Bank of England’s 2 per cent target.
Given that the UK unemployment and savings rates are rising and that both major political parties are talking about spending cuts next year, it is difficult to
imagine a quick return to a bubble economy. Similarly, the unwinding of fiscal incentives and a distressed consumer sector should keep a lid on inflation potential in both the US and Eurozone for the foreseeable future.
While a gradual move lower in the value of the dollar cannot be ruled out, political will is likely to ensure a decent degree of support for the buck. During 2010 the market will have to face the fact that the dollar is set to retain a dominant position for some years to come and that inflation is likely to remain contained in the medium-term.
The rally in gold and other commodities last week was thus built on shallow foundations and a sharp correction in the months ahead could be on the cards.
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