Doubts of Dollar Dominance are Taboo, but Gold’s Message is Glaring (August 26, 2024)

Americans’ diminishing purchasing power warrants consideration of alternative currencies

Jerome Powell revealed more in Jackson Hole than the Federal Reserve’s intention to begin cutting interest rates next month. His callous comments about inflation showed a lack of appreciation for the damage the central bank has done to the U.S. dollar and American prosperity. Investors might heed his remarks as a warning, if an unwitting one.

Discussions of declining dollar dominance have long been relegated to the fringes of economics and finance, treated as a form of doomerism that is as unrealistic as it is taboo. But reality is changing fast, and denial, as policy makers disrespect the dollar, will only exacerbate the consequences of any potential regime change.

“The good ship Transitory was a crowded one, with most mainstream analysts and advanced-economy central bankers on board," Powell joked Friday. Laughs were audible as he went on to say that in the audience he recognized fellow “shipmates.”

Inflation continues to cool, but it is still above the Fed’s stated 2% annual target. What is more, prices as measured by the consumer price index are up 22% since April 2020. That is another way of saying that Americans have lost more than a fifth of their purchasing power in about four years.

Gold tells an even more damning story of the dollar’s purchasing power. The metal’s march over $2,500 hasn’t happened in a vacuum. Nor has it been a coincidence. As commentator James Rickards puts it, gold’s ascent “tells you little about gold and everything about the dollar. Gold is the ocean, the real measure of things.”

Depending on the ear, Rickards comments sound poetic or dramatic. Either way, the point is crucial. Even when inflation is moving in line with the Fed’s target, monetary policy is set to devalue the dollar by 2% a year. Since April 2020–the same window during which the CPI rose 22%--gold has risen 49%, highlighting the damage already done to the dollar.

If interest-rate differentials normally drive the dollar, it is no surprise that imminent Fed rate cuts are weighing on the currency. The decline has been broad and not just against the euro- and yen-heavy DXY, an index measuring the value of the dollar against a basket of six major currencies. Peter Boockvar of Bleakley Financial Group notes that the Indonesian rupiah and the Thai baht are at the highest since early January, the Korean won is at the highest since March, and the Singapore dollar is at the highest since January 2023.

But there is more afoot. Consider a recent report from Citigroup saying that hedge funds are swapping the dollar for the yen to fund carry trades, where investors borrow in a low-interest-rate currency and invest the proceeds in higher-yielding assets elsewhere. It is true that the Bank of Japan has lifted rates off the floor at a time when the Fed is about to cut rates, and it is unclear how much of a dollar carry trade is actually happening. But the fact that Citi is observing it at all suggests there is more at play than expectations for a somewhat smaller gap between U.S. and Japanese rates.

Boockvar asks rhetorically at what point will the dollar reflect worries about U.S. debt and deficits more than expectations about Fed policy. Gold may suggest we are nearing that point.

Unlike past periods of credit-driven inflation, the inflation of our time is because of monetary debasement that shows no sign of abating, says Dan Oliver of Myrmikan Capital. The U.S. debt-to-GDP ratio is now 122%, well above levels that get countries into distress. He adds that this level of debt was matched in 1946, but that was at the end of war spending; the debt fell to 32% of GDP by 1980.

Regardless of who wins the next presidential election, deficit spending will worsen. That is not to mention state spending, such as generous home-purchase proposals for migrants in California and Oregon.

Oliver says that if we are living through a repeat of the 1970s, investors shouldn’t expect a cataclysmic collapse of the stock market despite “ridiculous” valuations. Stocks would instead lurch higher and lower within a trading range for the next decade, ending at roughly the same nominal price but worth 90% less, he says.

In the scenario Oliver lays out, gold as a baseline reference to the dollar will reveal the true measure of monetary carnage. The metal rose twenty-four fold from 1971 to 1980, and he notes gold went from representing 12% of the Fed’s balance sheet to 133% in the final dollar panic. Because gold currently represents just 8.8% of the Fed’s assets, it would need to jump 36% to $3,300 an ounce just to get to the 1970 low, Oliver says. Foreseeably, gold’s value, as measured in dollars, could be much higher.

Gold at $3,300 or more is no longer far fetched. Societe Generale chief FX strategist Kit Juckes says that since the start of 2020–during which period gold has gained 57% against the dollar–super-easy global monetary policy, downward pressure on inflation-adjusted yields resulting from post-Covid inflation, and geopolitical uncertainty have driven gold’s performance.

More recently, a new source of potential support has been creeping in. “There is increasing speculation that the dollar's hegemony in the international financial system is being eroded, partly because the U.S. government is using it as a tool to police international behavior, and partly because the global economy itself is splintering,” he says, referring in part to the seizure of Russian assets in response to the country’s invasion of Ukraine,”says Juckes.

An inevitable catch-up by investors in the West may be imminent. Boockvar, who remains long and bullish on gold, calls it “amazing” that Western investors have “completely missed the rally [in gold], as measured by the 23 million ounces of gold taken out of all the gold ETFs over the past few years.” That process started just as the Fed was hiking rates in March 2022, when investors favored interest-bearing bonds instead of gold. “At some point, that Western investor will be back and will kick start the next leg higher in gold,” Boockvar says.

In his most recent annual report, Ronnie Stoeferle of the gold hedge fund Incrementum lays out stats that underline Boockvar’s point. Here are some. Data from investment company Asset Risk Consultants show that 75% of money managers surveyed have minimal-to-no gold exposure, with none exceeding 10%. A Bank of America study from late last year showed that 71% of U.S. financial advisors allocate less than 1% of their clients’ portfolios to gold. That compares to a rule of thumb that gold represent 2% of an investor’s net worth. Stoeferle points to academic and industry research, plus his own quantitative analysis, to recommend a gold allocation between 14% and 18%.

Investors are familiar with the “cleanest dirty shirt” argument, where presumed dollar supremacy is based on bigger problems abroad. But that view is increasingly too narrow. Already, interest payments on the debt represent about 40% of tax receipts, and it is unlikely that any new administration will dial back spending–especially as unemployment rises. Investors should at least entertain the possibility of a regime change as fiscal irresponsibility, inflation and unlawful asset seizures swirl to undermine the dollar.

Perhaps what is old will be new once again.