Interest Rate Increases & Continued Gold Devaluation
By JC Collins
I’m just going to come right out and state it with absolute clarity. Gold will continue to depreciate.
Not only that, but the Fed will continue with the planned incremental interest rate increases which are set to begin at any time now. The normalization of monetary policy is considered impossible by many analysts and economic commentators. This is mainly because the larger play, being the transformation of the monetary framework, is not fully understood.
The incorrect assumption is that the US dollar will be replaced as the international reserve currency by the Chinese yuan, which in turn will cause the USD denominated assets (Treasuries) in the foreign exchange reserve accounts around the world to be “dumped”, leading to a flood of dollars coming back to American shores and causing the ever-threatened and often-predicted hyper-inflation.
It is concluded that this hyper-inflation will see a mad rush into gold and silver, leading to upward valuations in multiples of thousands. With so many other alternatives developing (explained below), does this seem like a realistic scenario?
The volatility surrounding everything from commodity prices, exchange rates, sovereign debt, and equity markets, are jumbled together in passionate conclusions of doom and gloom. We are told by many that the only viable means of protecting ourselves is to purchase more and more gold, which continues to decrease in value more and more.
Common-sense would strongly suggest that there are multiple paths forward from the point where we currently are located. Though gold has its own unique and valuable qualities, and should be held in any strategically diversified portfolio, going “all-in” on one investment path is both harmful and irresponsible by those who promote such goofiness.
Let’s explore this in more detail.
Putin, the much-lauded savior of the misinformed world, has called for the end of using the US dollar in trade amongst Eurasian countries. The time frame given for this change is between the years 2025 and 2030. Hardly the mad rush out of dollars that is being widely promoted and regurgitated.
Russia, China, and most other emerging economies, along with some developed countries, are overtly calling for the diversification of the foreign exchange reserves. The large accumulation of USD in these accounts has caused dramatic and unsustainable imbalances in the international monetary framework.
The most recent example of this can be found in the strength of the dollar over the last 6 months. This dollar strength has put incredible downward pressure on the currencies of the emerging economies, forcing some to devalue their domestic currencies in order to maintain the exchange rate regime which has held against the dollar for decades now.
China has demanded that the Fed does not raise interest rates as this would further strengthen the dollar and put even more pressure on the yuan. But perhaps this is exactly what needs to happen, as such actions by the Fed, being the normalization of monetary policy, will force the fragmentation of the existing USD exchange rate regime.
This would fulfill the plans of the US themselves to have the foreign reserves accounts diversified.
I was recently asked during a business dinner how I could expect the dollar to depreciate at the same time that interest rates begin to increase. Linear logic would dictate that an increase in interest rates would strengthen the dollar and cause its value to increase, not decrease.
But what isn’t considered in that path of logic is the diversification of the foreign exchange reserves (being the reduction and replacement of USD in those foreign reserve accounts) with alternative assets. This diversification will allow for the USD exchange rate arrangements to begin transitioning.
China has already begun to do this with its recent changes to its fixed daily rate. In the post China’s Rate Change Is Preparation for Widening of Trading Band, we reviewed how the PBoC will gradually widen the trading band in increments until a free-floating anchor is reached. This widening of the trading band will not just allow for the yuan to depreciate, but it will also allow for the yuan to appreciate higher as China slowly diversifies its foreign exchange reserves in increments over the coming years.
Less demand for dollars means lower value for the dollar.
It is probable that the PBoC will even maintain a strategic level of USD in its foreign reserves account.
The other part of this equation is that China will not be the only country diversifying reserves. As mentioned above, the Eurasian members, led by Russia, will also be diversifying foreign reserves, as will some American allies in the coming months and years.
This is not a slight against the US dollar, and it does not mean that the dollar will collapse or die a horrible death upon the jagged shores of hyper-inflation. It simply means that other countries, along with the US themselves, recognize and accept the need to reverse the accumulation of USD in the foreign exchange reserve accounts around the world.
Keep in mind, there will still be a level of USD in those accounts. The difference will be in the compositional balancing of those reserve accounts, primarily amongst three core reserve currencies, the dollar, euro, and yuan.
Though some countries and regions, such as Japan and the Euro zone, may still utilize non-normal monetary policies, such as QE and low interest rates, for some time yet, the US will now be moving forward on the normalization of monetary policy and will not implement any new QE strategies, and will begin to increase interest rates.
As stated above, this normalization of monetary policy will begin to force the required changes and give both the American administration and the Fed the necessary blame-shifting opportunity which would otherwise not be available to them.
The sole-dominance of the dollar is beginning to erode and nothing will stop this diversification from happening.
When the yuan is finally severed from the USD and stands alongside the US currency and the euro as one of three primary reserve currencies, all three will be competing for dominance in a monetary world of volatility and shifting balances.
We can expect increased instability in exchange rates, financial markets, and the ability of the US to fund deficits, which is directly related to the push for solutions on geopolitical hotspots, like Iran and Cuba. Reduced deficit spending means less to spend on manipulating the rest of the world and moving military hardware from region to region.
The balancing of the monetary system around three core reserve currencies is also reflective of the geopolitical challenges and tension which has developed in Eastern Europe and the South China Sea. These are the areas of the competing currencies to the dollar, being the euro and yuan.
The Fed can no longer neglect its dollar policy, and normalization must begin. Initially, when financial volatility surges (we are in the early stages of this now with just the hint of a rate increase), it will push the dollar stronger and force further action from China and other emerging markets, like Vietnam.
As the broader diversification of foreign exchange reserves deepens, the historical increase of the USD and the decline in the value of other currencies will begin to lessen. As the USD exchange rate arrangements begin to fragment it will become more important for the US to have the dollar depreciate.
This depreciation will be assured with the diversification of the foreign reserves. Less dollar demand. Basic economics.
The corresponding volatility, initially caused by the diversification, will begin to be offset by the additional (and alternative to the USD) safe havens of the euro and yuan. This is where most analysts have gone astray on future gold valuations.
The nature and history of fiat currencies have been overused to support the conclusions of appreciating gold. Though historical measures can be used as a reference point, and place of origin for evolving analysis, it does not necessarily reflect a certainty for how future trends will unfold.
What we are witnessing in the monetary world today is the re-balancing of currency as opposed to the collapse of currency. Some will appreciate and some will depreciate. All will leverage one another in a new framework which will slowly emerge in the coming months and years.
This transformation will ultimately reach the point where a multilateral asset (the SDR being the obvious selection) will be utilized to further balance the international monetary framework. How long it takes for this happen will largely depend on the level of expected and unexpected volatility which ensues.
In the meantime, the USD will begin to depreciate.
It can be expected that the decrease in value will be in the 20% to 30% range. There are a number of reasons this will be the range. The decrease in the dollar will increase the costs of imports for Americans. This increase in import costs will be offset by the increase in domestic production which will unfold from the decrease in the cost of American exports.
With the increase in domestic production and jobs, the momentum to increase minimum wage will grow. It’s hard to imagine the minimum wage increasing higher than the 20% to 30% range which is widely discussed. Though this is not the tell-all metric by which to measure any dollar depreciation, it is a solid place to begin further analysis.
So, with the much hyped collapse of the dollar unlikely to happen, and the rise of dollar alternatives, found in the expansion of the euro and yuan safe havens, we can expect that gold, after some initial volatility itself, will continue on its downward trajectory of depreciation.
Funny, while we are told it’s the increase in interest rates, and the overall normalization of monetary policy by the Fed, which will push gold into appreciating, it is actually the opposite. But take heart, the opportunity to buy gold at even lower prices than today will provide future generations with stable wealth growth as the precious metal begins to appreciate again over the coming decades.