Thursday, November 06, 2008

The Dollar: Discernable Impoverishment
November 6, 2008

Thank you, readers, for your many emails and financial contributions over the past few days. I will respond to each one as I catch up.

Yesterday I asked, "Are we being impoverished in ways we can barely discern?" Living in an economy with a depreciating currency is one way to slowly become impoverished, as the declining purchasing power of the currency means it requires increasing hours of labor to buy the same real goods.

Global inputs such as oil go up in price as the currency declines, as sellers demand more of the currency to compensate for its diminished purchasing power.

Longtime correspondent Cheryl A. recently asked for an analysis of the dollar vis a vis other key currencies, and so I asked frequent contributor Harun I. for a few charts and his commentary.
To provide a view of actual purchasing power, Harun has charted the currencies in terms of gold: as in, how much gold could the currency buy at any one point in time?

Please go to to view the four charts.

"The recent stories of people not wanting to open their 401K statements and the observation that $10 trillion in nominal gains in the US equity markets being wiped out in the past two months may be real but they are misleading. Much more actual wealth has been wiped out and has been ongoing since 2003 as indicated by the Dow/Gold ratio. For those afraid to look at 401K statements, you are 5 years too late; the market is just beginning to catch up to reality.
Mark-to-model: What is the difference between the government, the Fed, or Wall Street setting prices (stating absolute value)?

Axiom: Nothing is worth more than that for which it can be exchanged.

Relative Strength (RS) (also known as spread chart) is a comparison between two assets. Why are RS charts important? Because they tell us how much we can get of commodity (b) in exchange for commodity (a). It also tells the trader or investor whether what they are holding is increasing in value, decreasing, or staying the same.

In the first case let’s imagine there are 3 individuals. One has 100 apples, the other has 100 peaches, and the last has 100 bananas. The individual with the apples wishes to purchase as many bananas as he can for 10 apples. He finds that 1 banana is worth 2 apples; therefore he can purchase 5 bananas.

But he also knows that 1 apple is worth 2 peaches and that 1 peach is worth 2 bananas. He has no desire for peaches but being an enterprising individual he uses his budget of 10 apples to buy 20 peaches and then exchanges his 20 peaches for 40 bananas.

If he held overnight and three other merchants arrived with each 100 peaches and consequently the next morning 1 peach is worth half a banana, he can only purchase 10 bananas.

Such is the importance of understanding relative value. Keep this in mind as you examine the charts.

The US Dollar Index has declined since 2001, which decreased its ability to purchase Gold and commodities. The red line is the USD relative to Gold. As the 12-month Rate-of-Change (ROC) indicates if you had purchased the USD 12 months ago you would have a 14% gain in the amount of Gold one could purchase.

If you bought the Euro and sold the USD (black line) you now can purchase 16% less Gold than 12 months ago. Since late 2005 the Euro strengthened against the USD, however, if it was your intention to use your gains to purchase gold or other physical commodities (red line), you lost. The Euro is underperforming the USD and Gold.

A similar scenario played out in the Japanese Yen (and all other major currencies). The Yen too enjoyed strong out-performance of the USD. Currently the JY/DX currency pair indicates the Yen is weakening against the USD but its ability to purchase Gold compared to 12 months ago has increased 5%.

With no suggestion explicit or implied, which asset makes the most sense to own?

Where might the USDX go? (Actually the better question is: what action will be taken by me if x, y or z happens?) From a purely technical perspective, it has already retraced over 61.8% of the 2006-2008 down-leg. Of the 2001-2008 secular bear market nearly 38% has been retraced. This 38% retracement level is confluent with the long-term linear regression line (heavy blue middle line) and multi-year price resistance (2004-2006).

As the levels indicate, this move could be just about over or just beginning. We can only "know" in the aftermath."

Thank you very much, Harun. It seems to me the key takeaway is that in relation to gold, all these currencies have declined in value/purchasing power. Thus a fleet-footed trader could have exchanged one currency for another at various points in time (or shorted one currency and gone long another) and still come out ahead in terms of the amount of gold he/she could purchase, but the easiest way to retain purchasing power was to simply own gold.

Since we live in a world which trades dollars for goods and services, it's worth asking how the dollar might fluctuate in terms of other currencies. Harun's answer is that we cannot know that. As traders, we can only be alert to the possibility this could be the start of a long-term rise in value vis a vis other currencies (even as all currencies continue declining against gold) or merely a brief counter-rally in a long-term decline.

As pure speculation, I wonder if the dollar is returning to parity with the euro. (Please read the HUGE GIANT BIG FAT DISCLAIMER below; this is not advice, merely the freely offered opinion of an amateur.) Financial pundits always seek "the reason" or the causal factors which will dictate an action or trend, and I hesitate to propose any such conditions in a market (the FX or foreign exchange) which trades the equivalent of the entire U.S. GDP ($14 trillion) every 7 days.

With that caveat in place, we already discern the cracks forming in the euro along the predictable north-south lines, with Spain and Italy having a quite different view from Germany, with France straddling the middle ground. Could the euro eventually break into several flavors of euro with differing exchange rates? That would seem to defeat the entire raison d'etre for the one currency, but the alternative might be the dissolution of the euro, which would be even more unacceptable.

It is not difficult to foresee the possibility that currency markets (FX) might begin devaluing euros until the tensions in the euro zone are resolved.

Keeping in mind that currencies are merely relational in value--as per Harun's example of the fruit traders--it is certainly possible that the euro zone's internal contradictions and conflicts might reduce its value relative the U.S. dollar, not because the dollar is so mighty but because it is perceived as less risky to hold.

We can also discern the possibility (raised here before) that a non-national currency backed by gold (i.e. an entirely commercial currency perhaps based in Switzerland for convenience and safety) might take root in a world economy in which all currencies are declining against gold (and eventually, oil).

Perhaps we shall all own some gold-backed "quatloos" as stores of value even as we continue purchasing local goods and services with our declining-value dollars, euros, yen, rubles, renminbi, etc.

Or, as many are suggesting, a new gold-backed regional currency might arise.

One last possibility--another regional currency backed by nothing but promises--seems to have no advantage over the euro, which is an existing regional currency. The only new currency which has any advantage over existing currencies would be one backed by gold or perhaps a combination of gold, silver and oil--stores of value which fluctuate but do not go to zero as currencies are wont to do.

One last observation: how can we be earning more nominal dollars and be worth more nominal dollars, but feeling so much poorer than we were in the past? Look no further than the steady decline in the purchasing power of the dollar for at least part of the answer.

Thank you, Ioan V. ($50) for your outrageously generous donation and continuing support of this site. I am greatly honored by your support and readership.

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