The Dollar and Gold and Inflation
By Ken Mahoney

So, why is the dollar weaker? We hear and read about it all the time.

A simple answer is interest rates. Unlike the interest rates in other countries, interest rates in the U.S. are at historic lows. Lower interest rates can be a boon to the economy by easing the purchase of big ticket items like your home and lower interest rates allow institutions to borrow dollars which they can sell to invest in higher rate currencies. This practice called “currency carry trade” in which investors borrow low-yielding currencies and lend high-yielding currencies weakens the currency that is borrowed because investors sell the borrowed sum and convert it to other currencies. The downside to lower interest rates is the increased chance of higher inflation and the reduced value of the dollar which then results in reduced purchasing power for the consumer. The Federal Reserve, however, has stated several times that it will keep interest rates low for the foreseeable future.

And what about gold? I'm glad you asked. In the past several weeks gold has gone as high as $1,070 an ounce and may be trending higher. Some experts and investors see the increase in gold as a result of the struggling dollar and a concern over inflation. On the other hand, it is difficult to see inflation as an issue with near 10% unemployment and 70% capacity utilization (a full 10% below its long term average). Remember, a simple definition of inflation is “too much money chasing too few goods”. With 10% unemployment, you get the picture. But when the dollar falls, investors buy gold as a hedge against the depreciation of the paper currency. As interest rates are so low, it’s a low cost hedge.

Further, the bond market does not appear too concerned with inflation. Wouldn't we see rates much higher in the bond market if inflation were a real threat? TIPS (Treasury Inflation Protected Securities) are telling us that inflation will be under 2% for the next 10 years.

It has been clear for months now that Asia, particularly China, is leading the economic recovery around the world. The Chinese government has implemented massive government stimulus and the result may be near double digit growth rates. China insists on pegging its currency to the dollar to protect their export market. It might actually make sense for the U.S. and China to organize an 'informal' G-2 to see if there couldn’t be a common denominator that would work for both countries. Currently, there seems to be some friction between the two countries, as they both want to export their way back to property.

While The University of Michigan consumer sentiment index fell last week – it showed higher gas prices and unemployment continuing to weigh heavily on consumers’ minds – other economic data points show recent improvement. For example, the earnings we have seen have been better than expected mostly because companies have cut costs (unfortunately, most of the cost cutting has been in the form of layoffs).

And so, we continue to have this push/pull dynamic with the economy, investor and consumer confidence, and the dollar.

I welcome the opportunity to discuss this email with you in greater detail. Please feel free to call me at 845/371-0101 or email me at kmahoney@auroracapital.com

And don’t forget to visit my blog for additional articles and comments - http://kenmahoney.blogspot.com/

Mr. Mahoney is a registered broker with Aurora Capital, LLC, an SEC registered broker-dealer and member FINRA and SIPC. Aurora Capital Brokerage, trades cleared by Legent Clearing.

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