Rather counter intuitively, the financial crisis will have to play out a bit more before gold benefits to the extent many have been expecting. Specifically, gold bugs need to wait for the current period of relative dollar strength to fizzle out.
LONDON (ResourceInvestor.com) -- Since the beginning of last month we have probably seen the most intense phase of the global financial crisis. Yet gold hasn’t reacted as explosively as many of its devotees had hoped. Instead, the yellow metal has found it difficult to hold the ground above $900 an ounce, let alone reach the levels in excess of $1,000 an ounce that we briefly saw earlier in the year.
The explanation lies in the stronger dollar, which has done a fine job of holding back the gold price. What has happened is that the financial meltdown has had a largely unanticipated consequence; it has brought a flood of U.S. money back home from overseas. Despite the somewhat diminishing role of the U.S. in the global economy, a great deal of the hot money in the world remains American.
So, as panic has really set in across the markets, U.S. investors have sold foreign assets to cover losses at home and in an instinctive retrenchment as the financial environment has become palpably more dangerous. As part of this process, U.S. investors have sold other currencies and bought dollars to take home with them, causing the greenback to strengthen. And of course, the stronger the dollar, the greater is the temptation for Americans to sell down overseas investments, so the process feeds on itself.
However, the flow of U.S. funds back home will eventually abate and, looking at the bigger picture, it’s hard to see recent developments in the financial crisis as positive for the dollar. For a start, the U.S. government has taken on enormous new commitments in an effort to purge the financial system. So have other governments, but U.S. government spending has been of concern to dollar watchers for a long time. Moreover, all the measures taken to contain the financial crisis come on top of the costs of, for one thing, overseas military deployments such as Iraq and Afghanistan.
Although it has now become apparent that the financial crisis will leave almost no corner of the globe entirely unscathed, it remains a U.S.-centred problem. No economy was more reliant on easy credit than the U.S., and many were a lot less reliant.
Another factor presently supporting the dollar is that financial institutions around the world have a particular need for dollars. This as it’s now a time when international financial arrangements, many of which are made in dollars, are unravelling. But this need is temporary, and when the shakeout is over the same demand for dollars will not exist. The U.S. will also now have a lesser role in international finance, partly due to the fact that some of its most significant financial institutions, e.g. Lehman Brothers and Bear Stearns, have now disappeared.
On the basis of all this it is difficult to argue that putting money either into dollars or into U.S. assets constitutes a flight to quality, despite the fact that a few people seem to see it that way. Furthermore, occurrences like China Investment Corp. getting billions of dollars stuck in a U.S. money market account make it likely that lasting damage has now been done to U.S. financial credibility.
After the current panic, a more rational appraisal of the world economic situation will have to be made. In your correspondent’s view, all these issues will come to the fore. The dollar will come under renewed pressure, and that will give gold bugs the show that they’ve been waiting for.
