Toby Birch

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By Toby Birch December 2005 TTG Newsletter

The reason why Greek Mythology is still relevant today is that it provides lessons on the tragedy of human behaviour which is both timeless and repetitive. One character that appeals is the Greek heroine whose name gave rise to the Cassandra Complex. Having been given the gift of prophecy by Apollo, who had ulterior motives for teaching her, she later spurned her Divine suitor. Although she could foretell the future, Apollo took his revenge such that she would never be believed by her fellow mortals. Without wanting to sound like some smart-alec guru with selective memory just for the good bits, this has been very much the case for my positive forecasts on gold over several years. The thrust of the argument was that over many centuries, governments at war tend to lose all financial discipline in order to win at any cost. The cost comes through a debasement or devaluation of the currency as debts build to pay for the war-effort. When government-manipulated money loses its purchasing power then investors head for real assets such as precious metals.

So far, we have witnessed the standard inverse relationship where a weaker dollar boosts the price of commodities generally and gold in particular. Since 9/11, Americans have been encouraged to spend remorselessly thereby sucking in too many imports and leaving a surplus of dollars in the market. The evidence for this is the huge US current account deficit. It would normally have led to much greater currency weakness but up until recently, Asian central banks were willing buyers of US dollars via Treasury bonds. This kept the spin-cycle churning with mass produced money in exchange for cheap imported goods. Things have now changed. Against all expectations (including my own) the dollar has strengthened in 2005. At the same time, the jingoistic but ultimately self-destructive call by US Congressmen to revalue Chinas currency is cutting off a vital source of demand for the dollar.

So what has given the currency a boost at a time when the big buyers are backing away? There are three one-off factors that are making the dollar burn brightly: like a shooting star it may look impressive and catch the eye but it is only a temporary, final flash. First, the fact the US interest rates have been rising, albeit too slowly, has pulled in a good deal of international capital flows looking for a home. Second, when hedge funds borrowed cheaply in dollars to invest overseas for the so-called carry trade, the effect of rising rates created a loss-making situation that had to be reversed. This is known as short-covering where investors scramble to reverse a trade, clear their borrowing and minimise losses. Finally, there has been a tax break for US corporations to repatriate profits but this expires at the end of 2005. This gave rise to a further flow of funds back to the States.

Just as the aligning planets were seen as a portent of doom in Greek Mythology, we now see a series of events coming up for 2006 that paint a negative picture. First, while the handover of Federal Reserve chairmanship is usually good for equities in the 3 months prior and 1 month after the change, markets have traditionally underperformed once the honeymoon is over. We should therefore be wary about equities going into March 2006. Second, the US consumer and government are so sodden with debt and liabilities that any significant rise in interest rates will topple both the property market and the economy. Finally, the pressure on China to revalue may well be the final push that sends the dollar into devaluation mode. Instead of exporting deflation to the USA, strengthening Asian currencies will import inflation.

A recent Federal Reserve announcement explained that they will no longer publish M3 money supply data; a figure that is scrutinised constantly by their European counterparts at the ECB. This is a very clever move because while the Fed appears conservative by raising rates the truth is they are swamping the economy below the surface with printed money. Some market participants understand that these factors are inflationary. This is why the gold price has broken through the $500 level and US bond yields are rising. It would also appear that gold is emerging as a currency in its own right because it is no longer a hostage to the fortune of the dollar. Gold should be looked on as an insurance policy for one's paper assets and not an investment in its own right: it should therefore not be traded but left well alone.