Merit Financial: Meltdown - The Relationship between Currencies and Gold

Stock markets around the world continued their brutal slide this morning. Last week proved to be the worst trading week for the DOW in more than 32 months, while other global securities markets followed in suit amidst the US debt ceiling debate. This week has proven to be even worse. Just this morning, the dollar lost more than 1.2% against the Euro, the DOW is down nearly 2%, and the S&P and Nasdaq are down 2.2% and 2.5% respectively. Needless to say, the last 8 trading days have done more damage to stock portfolios than even the most bearish analysts could have expected. The question is: Why?

The debt ceiling debates here in the US clearly shook global confidence in the stability of the American economy and debt picture. The catastrophic default scenario was averted however, when the bill to raise our borrowing limit was signed into law earlier this week. So why are markets responding so poorly? Wouldn't we expect an upswing in global stock prices as investors breathe a sigh of relief? That's clearly not happening. There is a more subtle issue at play here that has been mostly overlooked to this point. We're referring to the effect the debt debates have had on the dollar, and the effect that the dollar has had on other currencies.

If there is one clear lesson to be taken from the circus that was Washington last week, it's that our political system is in no way prepared to deal with our long term debt loads. We know this, and the rest of the world knows it as well. This is shaking long term confidence in the US dollar, as investors are realizing that the outlook for the greenback may be even worse than they originally thought. So we all know the dollar is going down, but the truly destructive force is actually not the dollar devaluation, but rather the chain reaction that it must cause as it falls.

Despite the Dollar's ugly performance over the last decade, it is still the world's reserve currency. It is the chief instrument of international trade, and it is the currency in which we, the largest importer in the world, pay for international goods. What all this means is that other nations do not have the currency flexibility that the US has enjoyed for decades. They must accept our ever weaker dollars in exchange for goods they produce at home for the same high cost. For nations who rely on exports (most of the rest of the world), the relationship between local currencies and the dollar can build or destroy entire economic sectors almost overnight. If their local currencies rise against the dollar, 100% of the increases come straight out of profit margins for producers and exporters. Thus when the dollar slides 2%, it costs exporting nations about 2% of the income they would produce from the largest trading partner in the world.

In order to sustain profitability and economic growth, nations are being forced to devalue their currencies to keep them from appreciating against the dollar. This means that when the dollar slides, it will drag other currencies with it as a matter of fact. Just this morning, Japan intervened in the currency markets, selling enough yen on the open market to drive the Japanese currency down 4%. They were forced to do so by the 5% slide in the dollar that occurred last week.

Now of course there is another problem. What about the nations that export to Japan? Didn't their exports just become 4% less valuable overnight? How long can they afford to go without devaluing their currencies to keep pace?

Here at home, July jobs data is due out this week. Analysts are expecting weak data as a best case scenario. If job increases come in under estimates, it will certainly strengthen the case for another round of quantitative easing. The Fed is already positioned to pump more stimulus money into the economy, which will drive the dollar down even further. If this happens, how would Japan likely react? What about Brazil, Switzerland, Singapore, New Zealand, and all the other nations whose currencies have appreciated drastically against the dollar in the last month? They will be forced to devalue their own currencies to keep pace. Switzerland has already lowered interest rates (just this morning) to devalue their currency for the same reason.

As you can see, this can cause a chain reaction that can be very difficult to reign in. In competitive currency devaluations, the race to the bottom accelerates itself as nations struggle to purposely keep their fiat currencies from retaining value. This could be the beginnings of a currency war, and it's looking like Japan may have just fired the first shot. If we roll out another round of quantitative easing, we will have returned fire. Of course individual investors and savers are wiped out in this scenario as the purchasing power of money erodes very quickly. This is where gold comes in, and this is why it has hit yet another all-time high this morning, over $1680 per ounce.

Since gold is the only international currency that no one can devalue, it becomes the de facto safe haven as it has for thousands of years. That simple fact is what's driving this massive upswing in gold prices. Keep in mind however, that we're not just seeing gold increase in value. We are watching currencies fall apart before our eyes. In a sense gold isn't really going up…it's just the only thing that's holding its ground. So is $5000 per ounce gold in the next five years outlandish? That depends entirely on what else you can buy with $5000, five years from now. If we're paying $30 for a jug of milk, wouldn't $5000 gold be a steal? Unfortunately, we will find out sooner than we like.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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