gold / oil / us dollar

GOLD IS THE NEW "GOLD"
By Dan Denning

How can the dollar strengthen, even while America's
monstrous deficits are growing? And how can the dollar
strengthen, even while gold is rallying? The readers of my
investment letter, Strategic Investments, have been asking
many questions like these over the last few weeks.

To respond, let me begin by quoting a currency-trading
colleague in London. He correctly forecast the dollar's
rise in 2005. But like me, he's an avowed dollar bear.
Here's what he wrote recently on dollar strength:

"It's true that this phenomenon seems to have a lot of
people wrong-footed and confused, but there are some very
clear and straightforward reasons why this is happening:

"-- Market consensus runs the other way: One of our biggest
calls toward end of 2004 was that the USD would surprise
everyone with its strength in 2005. During the final blow
off rally in EURUSD in December, the market was massively
bearish the dollar, which, as you know, was then completing
three consecutive years of weakness. End 2004 was the first
end-of-year when I saw most market participants forecasting
continued weakness the following year. In the previous
years of the dollar sell-off, most end-of-year forecasts
were for a dollar rebound. With most players lined up
against the dollar, market positioning actually favored
dollar strength this year.

"-- Repatriation flows: U.S. corporations are repatriating
profits earned abroad under the U.S. program allowing them
to do so at much lower corporate tax rates than normal.
This tax break expires at year-end, and I expect there are
still several tens of billions heading back. Hence further
flow pressure expected to favor the dollar.

"-- Oil: In the long term, high fuel prices lead to
conservation, but in the short term, demand is relatively
inelastic. Factories don't shut down, airplanes still run
on schedule (well, largely), and my nephew still leaves the
light on when he leaves the room. The United States
consumed 22 million bpd in January, and consumed roughly
that amount yesterday. Ditto the rest of the world. Since
globally we still require the same amount of oil every day
(indeed, overall demand is still growing), and oil is (for
now, at least) still priced in USD, the world requires more
USD every day to fund oil demand.

This adds further pressure in favor of a stronger USD. Gold
is another commodity adding upward pressure to the USD,
though, of course, it's a much smaller market.

My friend brings up several interesting points worthy of
elaboration. First, the effect of high oil prices on dollar
demand. Because the dollar is the world's reserve currency,
global commodities trading takes place, for the most part,
in dollars. In other words, if you want oil, you need
dollars to get it.

Rising oil prices, then, actually create demand for
dollars. That's one way of explaining how both oil and gold
can rise along with the dollar. Usually, if oil and gold
(commodities) are rising, it means the dollar is falling
(inflation). What we have now is a relatively strong dollar
due to demand for the dollar as a unit of transaction.

In fact, this line of thinking led me to recall a study
from McKinsey & Company that pointed out just how vital the
dollar is to global financial flows. The dollar is the unit
of global liquidity, as the chart below shows. Cross-border
financial transactions of any sort have to be conducted in
some currency. And for now, the dollar remains the dominant
currency.