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Business/Finance See other Business/Finance Articles Title: Something's gotta give in America Gold's switch in the past few months from being the inverse of the US dollar to going up with it is a sign of some big forces at work in global markets and economies. It may be "Pink sky in the morning" (the shepherd's warning). In the first half of this year the US dollar went up 12 per cent on the back of an interest-rate arbitrage play as it became clear the Federal Reserve Board in the US would keep raising cash rates until they were "neutral" (probably 4.5 per cent). At the same time gold fell 6 per cent, which was in keeping with its long-term position as an alternative "currency" to the greenback. By the way, the mysterious appeal of gold, despite paying no yield, is based on its character as an asset that is no one's liability, unlike all other financial assets. Liabilities can default or become devalued; gold is just gold. Between November 2003 and January 2004, gold rose 10 per cent and the dollar fell 9 per cent; over the following four months those moves were reversed; in the second half of 2004 gold bounced 20 per cent while the dollar fell 12 per cent, and in the first half of 2005 the dollar regained the 12 per cent and gold fell 6 per cent. Since September gold has risen 9 per cent to an 18-year high as the dollar has risen 7 per cent - which is virtually unprecedented. It has happened because oil revenues are being recycled as much into gold and domestic investments as petrodollars (remember them?), while Asia continues to recycle trade surpluses into US treasury bonds (and thus dollars). So what's the problem? It's that the US dollar is overvalued and the country's competitiveness has eroded to the point where the cash rate arbitrage will be pitifully inadequate to hold the currency. This has occurred because Asian central banks, led by China, have been buying US bonds at ridiculously low interest rates in order to keep their own currencies and improve their own competitive position. US consumers and businesses have been buying their goods from - and outsourcing their services to - cheap currency countries, which has stopped what would have otherwise been a natural depreciation of the dollar. As a result, the US current account deficit is now pushing $US800 billion ($1086 billion), $US300 billion higher than when, as research house Bridgewater Associates puts it, "private sector capital gave up on the dollar in 2002". It is also the biggest financing task the world has ever known. Meanwhile, Asian current account surpluses are declining and those of oil-exporting countries are rising. According to the ANZ Bank's Saul Eslake, current account surpluses of the Middle East have quadrupled in two years to more than $US200 billion. Russia's surplus is up to $US120 billion and even Latin America is running a surplus now because of oil from Venezuela. In fact, Australia is about the only commodity exporting nation still running a deficit (because we are bigger consumers). Total trade surpluses of commodity exporting nations are about $US400 billion. Asian surpluses, meanwhile, have declined from $US370 billion a year to $US300 billion, so the most important financiers of America's consumption addiction are no longer the Asian countries supplying the finished goods and services acting out of self interest - what Eslake calls the greatest vendor financing scheme in history. Commodity exporters, especially oil, are taking over, and they have an entirely different set of motivations. Morgan Stanley's chief economist, Steve Roach, is in the middle of a spin through Asia and the Middle East, and filed an interesting piece for his website from the Emirates Palace Hotel in Abu Dhabi. He quotes a friend of his who "shared what I believe is a very important insight on the recycling of the huge surge in oil revenues that has once again flowed into the region's coffers - estimated at around $US300 billion over the past year by many accounts". "Unlike the oil shocks of the past, which gave rise to the concept of the petrodollar - a recycling of windfall oil revenues into dollar-denominated assets - the current windfall accrues to a Middle East that is much better prepared for inward re-investment. "Take a look at year-to-date returns in the stockmarkets of the region's major oil producers - Saudi Arabia (+96 per cent), UAE (+179 per cent in Dubai and +85 per cent in Abu Dhabi), Kuwait (+84 per cent), Qatar (+77 per cent), and Bahrain (+32 per cent). Also take a look at the urban construction boom - Dubai is starting to look Singaporean in scale." And they are investing in the other asset that is no one else's liability - gold. Certainly the Arabs are less inclined to finance American consumers than the Chinese and are more worried, as investors, about the sustainability of the US current account deficit. The US dollar is rising at present - along with gold - because of a short-term arbitrage on cash rates as the Fed continues to push them towards 4.5 per cent, whence chairman Ben Bernanke is likely to stop and sit on the sidelines for a while. Bond yields have also been rising gradually because global growth is surprising on the upside (not because of inflation expectations, which are not rising). This situation cannot last. American financial assets will have to be repriced eventually, either directly or through a depreciation of the currency, or both. And while there is little doubt that we are in the midst of a "Santa Claus rally" on Wall Street or that Australian stocks are generally not expensive, the timing and force of the American reckoning will be the key to investment markets in 2006.
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