The U.S. Dollar is Not the Euro

It appears that the scramble for financial lifeboats has begun, at least at the currency level. In today's Daily Reckoning, we'll show you how the U.S. dollar strength is another way of reading the euro its last rites as a reserve currency. You'll also see why now may be the best time to buy gold for the rest of 2010.

But first we have to deal with the Fed. As you know by now, it raised the discount rate - the rate at which the Fed charges banks to borrow from it - by 25 basis points to a whopping 0.75%. Markets took this as a sign that the Fed is tightening monetary policy and beginning its 'exit strategy' from quantitative easing. The dollar rallied (more on that below).

Not so fast! The Fed made clear that it was raising the discount rate in order to encourage banks to borrow from one another and not the Fed. It wants the banks to play nice instead of doing business at the discount window. And it explicitly said it is not raising rates as part of a "tighter" monetary policy.

To be exact, the Fed statement read, "The modifications [to the discount rate] are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy." Pretty clear there, isn't it?

Of course the Fed could be saying one thing and meaning another. But what it says and what the market hears can be different anyway. And the market seems to think the Fed's move supports the dollar. The bullish move in the dollar was crystallised by what traders call a "golden cross." See below.

It's a bit ironic a bullish move on the dollar index is called a "golden cross." But what to the traders mean? A "golden cross" is when a 50-day moving average crosses up against a 200-day moving average, which is also on the way up. It's doubly bullish, with an extra kick of momentum. But does the Fed's small increase in the discount rate really account for this?

We'll answer that in just one second. But when we asked Murray this morning whether the crossing of the 50 and 200 day moving averages was a big a deal as the headlines said, he said it wasn't as useful indicator as the crossing of the 10-day and 35-day moving averages he uses. And then he sent us the chart below and told us that if the dollar index breaks through 79 (it's at 80 as we speak), to look out for 84 as the next resistance.

On Murray's chart, the blue line is the 10-day MA and the red line is the 35-day MA. The 84 level he mentions corresponds to the middle of the dollar indexes' price distribution (the overlaid lines). This is exactly the same type of analysis Murray uses to generate trading ideas. And the dollar's move is meaningful, given he has several long gold positions at the moment. We'll let you know how those go.

But back to the key question: does the dollar's strength come from the Fed's move to raise the discount rate? Is this an "all clear" that worst of the crisis is behind us?

Definitely not. The dollar's fundamental strength is not improved by a quarter point hike in the rate which the Fed charges banks to borrow. The annual fiscal deficit in the U.S. is in double digits as a percentage of GDP. The Congress is gridlocked. Many of the U.S. states are going bankrupt. And as Albert Edwards showed this week, the U.S. is insolvent.

None of those facts argue for a stronger dollar. But one thing DOES argue for a stronger dollar and that thing is this: the U.S. dollar is not the Euro.

In other words, the currency markets are telling us that the Euro's ambitions as a global reserve currency may be dead. As an experiment in a managed currency designed to rival the dollar, it's failed. Greece may be the proximate cause. But the design of the euro itself - one monetary policy to go with many fiscal policies (and fiscal deficits)- was the first cause.

As the main rival (amongst paper currencies) to the dollar as a global reserve currency, the euro's coming collapse has to, almost by definition, equal dollar strength. There just aren't that many more liquid alternatives for large institutions and central banks. They can diversify amongst higher yielding currencies and tangible assets. But the massive liquidity offered by short-term U.S. government debt markets is too easy to resist.

So everyone is piling into the dollar as a paper money lifeboat. The dollar's inherited status as reserve currency has trumped (for now) the fiscal and monetary mismanagement of the U.S. political establishment. We think this makes now a very good time to buy gold.

Of course it might not see that way given that the gold price fell sixteen dollars in New York trading to $1,102. The superficially bearish news is that the IMF wants to complete the gold sale it announced last year by selling another 191 metric tonnes from its inventory.

Remember last year the IMF announced it would sell 403 metric tonnes of gold. The first 200 tonnes were sold, in a bit of surprise, to the Reserve Bank of India. The conventional wisdom had pegged China as the likely buyer.

Selling the remaining 191 tonnes would reduce the IMFs holdings by just one eighth. It would still be the third largest holder of gold reserves behind the United States and Germany. But is this bearish news for gold? Will there be any buyers? With the greenback rallying, will gold suffer from a supply dump on the open market via the IMF and a rampaging dollar index?

We'll see. But we'd guess that gold's going to be just fine. Just remember that all three buyers of the IMF's last gold sale were central banks. The Central Bank of Mauritius bought two tonnes and the Central Bank of Sri Lanka bought ten tonnes. Central banks are still really the only institutions in the world that hold gold as a real monetary reserve.

Our guess - and we should make clear it's just a guess - is that the IMF announcement will work out nicely for some central bank somewhere. The announcement will push the price of gold down temporarily, allowing a central bank to add to its gold reserves at a lower average price. But why would central banks be loading up on gold?

Well, if they're unloading the euro and, in China at least, the U.S. dollar, they have to load up on something more tangible. So perhaps someone is twisting the IMF's arm to sell more of its gold so certain sovereign nations are in a better position to survive in the event of sovereign debt default by one or several European States.

But we'll make it simple for you. We're headed back to the States next week for a quick trip and our intention is to sell the dollar on strength and buy gold. We'll tell you how later.

For the moment, none of this major deck-chair scrambling in the global currency markets is affecting Aussie stocks prices. The indexes are up as we right. Reserve Bank Governor Glenn Stevens repeated the view, although these weren't his exact words, that Australia has decoupled from America in the sense that future earnings and economic growth will come from trade with Asia.

That may be true, although we have our doubts. But the other question is whether Australia's financial markets have decoupled from instability and volatility that originate in Europe and America. We suspect they haven't. And for that reason, watch out. It's going to be a crazy year.

Dan Denning
for The Daily Reckoning Australia

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