There's a simple reason why I think that all the dollar doomsayers are wrong: I'm bearish on the euro.
It's fashionable to bash the dollar right now. Fundamentally, there's not much to like about the U.S. currency -- deficits as far as the eye can see, ultra-easy monetary policy, high unemployment, and a still-far-from-stable banking system.
But as we found out in December, the euro is not much better. The euro fell from $1.51 to a recent low of $1.42. This is one reason why we saw a large correction in gold bullion and gold stocks, and a sizeable sell-off in some sovereign bond markets, but relatively little impact on U.S. stocks.
There's more to come in the euro decline
As it turns out, I was early in calling for a drop in the euro; the dollar has spent most of 2009 giving up its gains from a year ago. But even though my timing was bad, my article's long-term fundamental views on the euro's future were sound. Finally, the market has begun to realize that.
The euro truly is the key to the dollar's overall health. If you look at the weightings in the basket of currencies that make up the Dollar Index, you'll see that the euro makes up more than half of the index. So if you're bearish on the euro, you almost automatically have to be bullish on the dollar.
Before you dismiss the argument out of hand, consider that the euro has a structural weakness: There is a European Central Bank, but no single unified Treasury. Often, centralized monetary policy has been out of sync with fiscal policy among European countries, which can create substantial pressures on the euro. There is huge political risk that the market is only now starting to appreciate.
Uninformed comment?
This political risk has been most evident in weaker European economies like Greece and Ireland. The Greek and Irish euro-denominated sovereign bond markets have both sold off substantially, increasing the yield spreads between them and the benchmark euro-denominated German bunds. There have also been sovereign credit downgrades in the region, prompting one bank to speculate that Greece and Ireland might leave the euro next year. The Irish government called this speculation "uninformed comment," but it's clear that these and other countries are putting pressure on the euro's viability.
|
Country |
Purchasing Power Parity in Euros per U.S. Dollar |
|---|---|
|
France |
0.867 |
|
Germany |
0.803373 |
|
Italy |
0.830451 |
|
Spain |
0.742674 |
Source: OECD. PPP comes from latest available 2008 annual figures based on actual individual consumption.
As last year's purchasing power parity (PPP) figures for Europe's largest economies show, the euro is still wildly overvalued. At its current level of around $1.43 to the euro, a dollar is worth a little less than 0.70 euros. But as the table shows, it takes more than 0.70 euros to buy a dollar's worth of goods. To match up with the German PPP of 0.803, the exchange rate should drop to below $1.25.
In this environment, any political and economic issues among the weakest countries in the Eurozone are likely to pressure the exchange rate. I see more euro downside, which might hurt earnings of classic multinationals like Coca-Cola
Euro effect on gold
Over the past year, gold has moved in line with the euro's advance against the dollar. At the moment, a weak euro has been accompanied by weaker gold prices as measured in U.S. dollars.
Although troubles in the U.S. seem to justify a weaker dollar, the fact is that most central banks are taking similar measures. Those actions arguably make all paper currencies equally bad stores of value, if the process continues ad infinitum. We have been assured of an "exit strategy" by many world central bankers, but we have yet to witness its successful implementation. This should be bullish for gold in the long term, but in the short term, I see a deeper correction as the euro declines.
Right now, gold bullion looks like a good buy near $1,000, and an even better value if it declines toward $900. I can assure you that such decline is possible if the turmoil on the Old Continent accelerates, and the euro drops to $1.25. Gold was below $900 in March, when the euro last traded at that level.
Based on that view, I would book gains in speculative positions in small-cap gold stocks, and look to buy quality names like Barrick Gold
Longer-term, though, the policies that governments are implementing have decidedly negative implications for currency values relative to gold. If those policies don't change, exchange-rate moves could easy pale in comparison to the increases that precious metals might see. Based on my estimates, gold would need to rise to nearly $2,500 just to match its inflation-adjusted record highs, which corresponds to around $250 for the SPDR Gold Shares
John Connolly, Nixon's Treasury Secretary, once told his European counterparts, "The dollar is our currency, but your problem." Soon enough, though, competitive devaluation could make weaker currencies everyone's problem.
More on market issues:
