Gold, Geopolitics, and the Carry Trade

The price of gold has recently spurted to a new all-time high in terms of U.S. dollars. I’m neither an expert nor a market timer, but let me offer a few perspectives on this event.

To most people, including gold bugs, gold is an inflation hedge, preserving purchasing power at a time of currency depreciation. Today, unlike the gold bull market in the 1970s, gold is rising while consumer and producer prices are falling. Nevertheless, many economically knowledgeable market participants are getting out of Dodge—that is, they are reducing their holdings of dollars now—some to avoid potential losses from future dollar depreciation and some for other reasons.

The market price of things reflects how much people value them. For people to value a currency highly, they must have confidence both in the integrity of the currency and, in the case of a fiat currency, the political and financial viability of the government issuing the currency. Confidence in the buck is currently low because Washington’s fiscal policy is profligate and out of control, and because Federal Reserve Chairman Ben Bernanke has stated that the Fed will create as many dollars as deemed necessary to prevent a depression. (For the record, there is no guarantee that monetary policy, inflationary or otherwise, can prevent a depression. It is possible to have a hyperinflationary depression.)

Market prices decline when sellers outweigh buyers. The dollar currently has lots of sellers. China, for example, is hedging its exposure to dollars by exchanging paper assets for hard assets, buying massive quantities of raw materials around the globe, while also encouraging its own citizens to diversify into gold and silver. There are recurring rumors that some Arab Gulf states, China, Russia, France, and maybe even Japan would like to replace the buck with a basket of currencies and gold for oil transactions. The Federal Reserve Note may become “the old maid” of the global currency markets.

Another important, but generally under-appreciated, factor affecting the price of gold is geopolitics. $800/oz. gold in January 1980 was, among other things, an emphatic no-confidence vote for the United States as a world power. Under Jimmy Carter, the United States appeared impotent and incompetent on the world stage. Soviet tanks rolled into Afghanistan, Iran held over 50 Americans hostage for 444 days, and everyone remembered how Carter had kissed Leonid Brezhnev. The dollar tanked and gold soared. When Ronald Reagan reasserted America’s resolve and effectively stood up to Soviet expansionism, the dollar entered a prolonged bull market and gold a prolonged bear market.

Today, President Obama seems paralyzed in Afghanistan, clueless about Iran, makes unilateral concessions to the likes of Vladimir Putin and Hugo Chavez, and gold is at record highs despite overall price deflation. Nobody wants to hold the currency of a declining power; hence, until our president starts projecting strength, the dollar is likely to remain under pressure. Many foreigners love to gripe about American power, but when push comes to shove, they generally prefer the relative stability provided by a strong United States and a strong dollar.

Another major factor affecting the gold-dollar exchange market today is “the carry trade.” This is a currency-trading technique whereby speculators (everyone from financial institutions to hedge funds to individual investors) borrow money at low interest rates in one currency, then sell that currency to buy another currency where they can earn higher interest rates, thereby profiting from interest rate spreads.

In recent years, the Japanese yen had the lowest interest rates, and therefore was sold to finance the carry trade. Incidentally, this policy was designed to prop up politically connected too-big-to-fail bankrupt banks, resulting in years of economic stagnation in Japan.

Uncle Sam and the Fed have adopted a similar program today. The Federal Reserve is keeping interest rates near zero, so currency traders are selling dollars (accentuating the already bearish trend in the buck) to buy other currencies in the search for yield. Since the Fed has insisted that it will hold interest rates at these amazingly low levels at least through 2011, many currency traders are selling dollars to buy euros, yuan, the Brazilian real, Canadian, Australian and New Zealand dollars, etc. (Note to amateur speculators: The carry trade isn’t as risk-free as it seems. If there is a financial panic similar to last fall’s, panic buying of the dollar might crush those who are “short” the buck.)

Incidentally, since one of the traditional arguments against buying gold is the fact that it pays no interest, today’s super-low interest rates on dollar-denominated savings practically eliminate the opportunity costs of converting dollars to gold, further incentivizing a shift from dollars to gold.

This economist doesn’t know the future, and this article isn’t giving investment advice. Gold prices may continue to soar or they may get caught in a deflationary downdraft. I will, however, make one categorical assertion: Gold is warning us that our country is on the wrong track.