Pay attention to China

Paul van Eeden
Mar 26, 2007

As usual, the market is over-thinking and over-analyzing the US Federal Reserve Open Market Committee Statement released Wednesday where the Fed conveyed its decision to keep the overnight interest rate steady at 5.25%. It appeared that the Fed's hawkish tone towards inflation was easing and even though the Fed expects the economy to continue to expand at a moderate pace over coming quarters, one has to wonder how much of the change in the Fed's tone is due to the current problems in the real estate sector.

While the dollar exchange rate showed little reaction to the Fed's statement, the equity markets in the US rallied, as did gold. That both gold and equities had the same response is to be expected: if the Fed is less likely than before to raise interest rates it may be more inclined to lower interest rates in the event economic activity takes a bigger hit from the real estate sector. Lower interest rates are good for stocks, lowering the borrowing costs of corporations and making bonds (which compete with stocks for capital) less attractive. Lower interest rates are also positive for the gold price since lower interest rates would most likely cause the dollar exchange rate to weaken, thereby increasing the gold price in US dollars.

But by Friday the market had changed its mind. According to interviews by Wall Street Journal journalists the market now thinks that Wednesday's Statement was not a move towards a dovish stance, but merely a move towards neutrality. In response to the change in sentiment the dollar rallied and the gold price fell.

As I said, I think people over-analyze these things. Short term fluctuations in the market are due to fickle emotional reactions by investors to new information, and are impossible to predict with any kind of consistency. On the other hand, longer term events that are based on fundamental changes or inconsistencies are far easier to predict even though the timing of such events is equally impossible to predict. Along those lines, a comment by the People's Bank of China's Governor, Zhou Xiaochuan, regarding that country's more than one trillion dollars' worth of foreign reserves, is far more important than what the Fed said this week.

Zhou was quoted as saying: "... many people say that foreign exchange reserves in China are large enough. We do not intend to go further and accumulate reserves."

China's vast and rapidly growing foreign exchange reserves accumulate because China does not sell the surplus US dollars that it receives from its trade surplus with the United States into foreign exchange markets, but buys US debt with them instead. Under normal circumstances China would have sold its surplus US dollars and not accumulated such a vast foreign exchange reserve; however, the United States' trade deficit is so large that if China, Japan and Europe were to sell their trade dollars into foreign exchange markets the dollar exchange rate would collapse.

Last year the Organization for Economic Co-operation and Development (OECD) determined that the dollar had to fall by 35% to 50% in order to balance the US current account gap. My calculations of the dollar's over-valuation based on the gold price also suggest that the dollar has to fall by about 35%.

China does not have to sell any of its existing dollar reserves to precipitate a decline in the dollar -- all it has to do is stop accumulating dollars. The current US trade deficit with that country alone is running over $20 billion per month, and that is not an insignificant amount. If China stopped accumulating foreign reserves those dollars would be sold and I expect that when that happens, the dollar will fall.

Other Asian countries that helped prop up the dollar by accumulating foreign reserves may follow China and start selling their surplus trade dollars as well.

The ramifications are that there will subsequently be less demand for US Treasuries and agency debt. That will push US interest rates higher regardless of what the Fed says, and higher interest rates will be detrimental to US economic growth and US equities. One would expect that higher US interest rates would be positive for the dollar, but with surplus trade dollars hitting foreign exchange markets we can expect to see the dollar fall in tandem with rising interest rates. A falling US dollar in the face of rising US interest rates is the key event that I am waiting for to indicate that a significant and sustainable rise in the gold price is occurring. Until then the gold price should continue to creep upwards as a result of fiat money inflation.

If you have been reading these commentaries online on third party sites you may have noticed that they do not appear as regularly as they used to. That is because I am sending them regularly to commentary subscribers and posting them elsewhere only occasionally.

Paul van Eeden
email: pve@publishers-mgmt.com

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