Inflation is Hot and Getting Hotter

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Inflation has been the talk of the town for months now. Inventory shortages, supply chain bottlenecks and other issues have all been linked to the steep rise in  U.S. inflation in recent months. Inflation has become so problematic at this point that even the Federal Reserve has acknowledged it after saying it believed it was only transitory in nature for a long period of time. Today’s latest reading of the Consumer Price Index only adds credibility to the argument that inflation is entrenched and here to stay. The gauge registered its highest reading in decades today, showing an annual price rise of a whopping 7.5%.

 

The 7.5% reading was above consensus estimates for a rise of 7.2%. The hottest inflation reading in some 40 years has put pressure on both stocks and the metals complex. The data falls clearly into the camp of the policy hawks, who want to see the Fed act aggressively with multiple rate hikes to battle rising price pressures. The reading also fueled a spike higher in treasury yields which is also adding pressure to the metals in early morning action. The benchmark 10-Year Note is currently fetching a yield of 1.994%, its highest yield in over two years.

 

The notion of runaway inflation is not new nor should it be discounted. The Fed has seemingly been well behind the inflation curve for some time now. The central bank could, therefore, be forced to act far more aggressively than previously anticipated. This aggressive action could come in several forms, including a faster pace of more rate hikes or a stringer hike to begin with. The Fed has not made a half-point rate increase since 2000, at which time the dot.com bubble burst and stocks went sharply lower. Some analysts have suggested that hot inflation could pave the way for the Fed to hike rates by a half-point in March rather than the standard quarter-point rise. While such a move could potentially help ease the rise of inflation, it is not without risks. Stock markets, for example, do not love the idea of higher interest rates. The era of free, easy money has been a major contributor to stock market upside in recent years, according to some, and without it the equity markets could potentially see a major slide and trend reversal.

 

Although gold is slightly higher this morning, the metal may remain range bound until the Fed does actually take action. The metal could see a rise during this tightening cycle as it has during previous tightening cycles, and moderately higher interest rates may not be enough to halt buying interest in the yellow metal. The bulls are not far from a key level they must breach. A close above the $1850 area could indicate a fresh leg higher for gold. The bears are targeting a close below $1800 and $1780. A close beneath these levels could set the stage for a fresh leg lower.

Gold Sharply Higher to Finish 2021

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The gold market is seeing some solid buying on New Year’s eve, the final trading day of the year. The yellow metal is putting in a good showing today to cap off the end of a losing year in which the metal declined by several percentage points for its worst annual decline since it lost 10% in 2015.

 

The yellow metal today is likely benefitting from some end of year position squaring and possibly some short covering. The metal is higher despite some weakness in crude oil today and some steadiness in the Dollar Index. Yields on the benchmark 10-year treasury are at 1.51%. The 10-year yield notched a .6% gain for 2021, the largest increase seen in eight years. Although yields have quieted down some in recent weeks, rising yields could remain a source of market tension in 2022 and could weigh on gold prices as the year gets going.

 

As 2021 winds down today, investors will turn their attention to the upcoming year ahead. Numerous issues remain that could affect the gold market, and volatility could see an upswing as the Fed gets ready to tighten policy. The two biggest issues being faced by the gold market for 2022 are monetary policy and inflation.

 

Inflation has been running hotter in recent months. Despite the Fed’s earlier assertions that inflation was “transitory” in nature, Fed officials have now seemed to acknowledge that rising price pressures are a problem and could be here to stay. It is these rising prices that have likely been the primary factor in the Fed’s decision to taper its monthly security purchases faster than anticipated and to pencil in three rate hikes for next year. If inflation accelerates further, the Fed could find itself forced to raise rates further and/or faster, and that could potentially upset markets a great deal. Any surprise action by the Federal Reserve could set the stage for a stock market reversal or a major sell-off.

 

Equity markets could also hold some keys to gold’s fortunes in the year ahead. If stocks do reverse course and begin trending lower, it could benefit gold and other perceived safe haven asset classes. A major equity sell-off could have the same effect, although investors holding gold could be forced to liquidate those positions in order to raise cash to meet equity margin calls.

 

Whether it is up or down, 2022 could be a breakout year for gold. The yellow metal has been range bound for several months now, with neither the bulls nor the bears having enough ammunition to stage a sustainable breakout or breakdown. That could change in the year ahead, however, as investors become more in tune with the Fed and its decisions on policy. For

the time being, the bulls will look to take out resistance in the $1840 area while the bears will look for declines to the $1750 level.

What Is A Premium?

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When looking to purchase a physical gold coin or bullion, one of the key considerations is cost. The spot price for gold is going to be the same anywhere in the world. Spot values for gold can vary based on a wide variety of factors. These factors may include dollar strength or weakness, sovereign debt levels, risk tolerance or aversion, stock market strength or weakness and more. Why then might the price of the same gold bar or coin be different from one dealer to the next? The answer is the premium.

 

A dealer premium is the amount of money added to the price of gold by the dealer. Premiums ensure that dealers make a profit when selling gold coins or bars. These premiums not only

cover the dealer’s cost and profit, however, but also cover other costs such as manufacturing, transportation or distribution and more. Collectibility can also have a major influence on premiums. The more rare a coin is, for example, the higher the potential premium on it may be.

 

Numismatic, or collectible coins, are often best left to professionals. The large premiums on these coins can fluctuate wildly, potentially producing profits but also possibly fueling significant losses. The average bullion investor today may be far better served by sticking with basic gold coins and bars with smaller premiums, thus providing more actual gold for the dollar.

 

Why are premiums so important when buying gold coins or bullion? Because they have a direct impact on how much you spend. The more you pay in dealer premiums, the less actual gold you are going to get for a specified amount of investment capital. If an investor is looking to purchase 50 gold coins, for example, he or she should definitely compare dealer premiums. If dealer A is charging $10 over spot per coin, while dealer B is charging $20 over spot per coin, then the investor can save $500 by purchasing the gold coins from dealer B. That $500 savings could be sued to buy more coins or gold bars, thus allowing the investor to obtain more actual ounces of gold for the money.

 

With so many metals dealers now doing most, if not all, of their business online, comparison shopping has never been easier. Dealers will usually post the cost per coin or bar including any dealer premiums attached to them. Many dealers will also offer discounts, i.e. you pay a premium of $10 over spot on the first 20 coins, then $8.99 over spot on the next 20 coins and so on. Put simply, the larger the purchase is, the more you may be able to save on premiums and total cost.

 

When comparing dealer premiums, take your time and make sure you compare apples to apples. A dealer that offers shipping included, albeit with a slightly higher premium, may in fact be a better deal than another dealer offering a lower premium with substantial additional shipping costs. Always keep in mind that the entire idea is to obtain as much physical gold as possible at the best price possible.

The Week Ahead in Gold

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The gold market is slightly higher in early action Monday as stocks and investor risk appetite take a break from recent upside. As of this post, the gold market is up about $.80 per ounce at $1460.50 per ounce. The market had traded over $1464 earlier in the session but has come off its recent highs.

 

There are several factors this week that could influence the gold and stock markets. Two of the biggest potential issues could be the proposed tariffs going into effect against China on the 15th, as well as the UK election being held on the 12th. Of course, investors will also be paying close attention to any key pieces of economic data as well as the ongoing trade negotiations between the U.S. and China.

 

The continuing Brexit saga has put markets back on edge in recent weeks as the deadline again approaches. Although Boris Johnson and the Conservatives have a double-digit poll lead heading into Thursday’s vote, the gap has been tightening in recent weeks and anything could happen. Even with a victory, Johnson and the political party may not be able to pull off a Brexit deal as suggested. Lack of a deal, or a no-deal Brexit, could potentially lead to heightened market volatility and uncertainty in the weeks and months ahead.

 

Although recent discussions appear to be productive, the U.S./China trade war continues, with further tariffs set to go into effect on December 15th. If these duties are implemented, it could potentially undo much, if not all, of the progress that has been made in recent talks. On Friday, China waived tariffs on U.S. soybeans and pork as a show of good faith in recent discussions. China may be hoping that the U.S. will follow suit, yet President Trump appears to have no plans of letting China off the hook. China has asked the U.S. to roll back tariffs as part of a “phase 1” agreement, but the U.S., thus far, appears unwilling to do so.

 

If further progress between the globe’s largest economies is not seen in the weeks ahead, investors could become uneasy and selling in risk assets could intensify. Such a scenario could produce a lose-lose situation for the Trump administration, which needs to make a solid, pro-U.S. deal with China on trade but may also need stronger stock markets as the 2020 reelection campaign gets into full swing.

 

The gold market has thus far held above the $1450 level and may continue to do so. Although a more serious dip cannot be ruled out, the market may simply be waiting for a fresh, bullish catalyst to take prices back towards the $1500 region or beyond.

 

It may be unlikely that the yellow metal falls much further than recent lows, however, as numerous long-term issues may remain supportive in the years and even decades ahead. These issues include rising sovereign debt levels, central bank monetary easing, weaker fiat currencies and an aging equity bull market that is likely to run out of gas at some point.

Precious Metals as Part of Your Estate

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Precious Metals and Your Heirs

Estate planning can be an extremely complicated and cumbersome endeavor. There are numerous assets that must be considered, including your home, autos and investments. If estate planning is not carefully planned, taxes and other issues can pose problems, leaving your heirs with less overall inheritance.

 

When many think of leaving, or bequeathing, assets to their heirs, the most common assets that may come to mind are homes, other real estate and investment portfolios. These investment portfolios often consist of stocks, bonds and other instruments.

 

Precious metals such as gold and silver are, in our view, great assets to pass on to the next generation. These metals have been recognized as a reliable store of value for thousands of years. They are traded and valued all over the globe, and carry no counterparty or default risk.

 

Why shouldn’t they be passed on as well?

 

By allocating money into precious metals today, you can accomplish not one but two important goals…

 

First, you can gain peace of mind knowing you have an asset that can potentially hedge your exposure to inflation, currency risks, geopolitical risks and economic hardship. These precious metals are very liquid and are in most cases transacted very easily.

 

In addition to these potential benefits, owning physical gold, silver or other precious metals may also add an additional layer of diversification to your overall portfolio, potentially reducing portfolio volatility.

 

Secondly, you can build a store of wealth for your heirs. Gold, silver and other precious metals can be passed on to your heirs along with other assets. And there are a few different ways to do this.

 

You can pass on coins, bars or rounds that you own and store at home, in a safe deposit box or other location such as a depository.

 

You may also have the option of passing on your precious metals holdings that are held within an IRA, trust or retirement account. This can be a way to pass ownership of your precious metals to someone else without necessarily having to have the metals physically delivered.

 

Unlike stocks, bonds or other “paper” investments, you are passing on something of tangible value that cannot be manipulated, go broke or go out of business. By passing on precious metals to your heirs, you can rest assured they are getting something of true value.

 

Of course, there are many rules and guidelines that must be adhered to when bequeathing your precious metals. Tax and estate laws can vary depending on your location, and must be strictly followed in order to ensure a smooth transfer.

 

We believe that right now presents a fantastic opportunity to begin planning for the future. Gold is currently at multiyear lows, while silver is not far behind. We do expect gold and silver prices to rise over time, however, and view current levels as an opportunity to buy gold and silver at a significant discount.

 

Not only could prices for these precious metals rise during your lifetime, but they could also potentially appreciate in value significantly during the lifetime(s) of your heirs.

 

By helping secure your own financial future today, you may also be securing their financial futures for tomorrow.

Could My Gold be Confiscated?

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Could My Gold Be Confiscated?

A common question that gold investors have is: “Could my gold ever be confiscated?” While the notion of confiscation-whether it is gold or any other property-may cause a degree of anxiety, one must also consider the facts surrounding such an idea.

 

When it comes to gold ownership and the idea of confiscation, one must also be aware of what has occurred in the past, and what could potentially occur in the future.

 

This brief guide will provide a short history of gold confiscation as well as discuss some key points pertaining to the possibility of a similar scenario in the future.

 

The U.S. Gold Confiscation

Modern day fears of gold confiscation are derived from history. On April 5th, 1933, U.S. President Franklin D. Roosevelt signed executive order 6102. This executive order banned the hoarding of gold bullion, coin or certificates within the continental U.S. The order went a step even further, however, and made gold possession by individuals, corporations, associations and other entities a criminal offense.

 

It is important to note that there were, however, some exceptions to this order. For example, the order exempted gold that was used in specific areas of industry and for art purposes. Gold coins that were considered rare and had special value to coin collectors could also be exempt.

 

While an individual could legally hold up to $100 worth of gold coin, executive order 6102 as well as additional executive orders led to multiple prosecutions.

 

Why Was Gold Ownership Banned?

In order to understand the rationale behind the gold confiscation, it is important to view it within the context of that time period. Difficult and extremely challenging economic conditions led to people and entities “hoarding” gold.

 

The Federal Reserve desired to use a method that is still in use today to battle the tough economic times. They wished to increase the money supply-essentially print dollars-in order to boost economic activity and growth.

 

The central bank faced a major roadblock, however, as the Federal Reserve Act required 40 percent of all bank notes issued to be backed with gold. This is in contrast to current times, in which central banks can essentially print all the money they want.As the Great Depression began to consume the nation, the central bank was running out of ammunition to fight the slowdown. With limitations on the amount of money that the Federal Reserve could put into circulation, the government had only one choice. It needed more gold in order to increase the money supply.

 

The government eventually devalued the dollar, while resetting the price of gold to $35 per ounce. The government’s wealth grew rapidly due to the increased value of gold. Monetary gains from the increase in the price of gold were then used to fund various new deal programs designed to get the country on more stable economic footing. It would be three decades before U.S. citizens were allowed, by law, to own gold certificates again. Another decade would then pass before President Ford along with Congress made gold ownership legal once again.

 

Could Such a Scenario Unfold Today?

Technically speaking, it is possible this could happen again. The government retains certain powers, and one of those powers is the ability to call gold in under specific circumstances such as war or declared emergencies. The laws regarding private gold ownership can vary, however, by nation. While it may be legal in the U.S., for example, it may not be legal in other countries. It is important to have an understanding of what your government’s particular laws may be.

 

While anything is possible, and this issue is certainly worth consideration, the likelihood of a large scale gold confiscation is slim.

 

For starters, enforcement of a gold call in could be extremely difficult. Many precious metals transactions today are not reportable, and transactions of this type are some of the most private. Secondly, any country that decides to confiscate gold would in many ways be demonstrating a lack of faith in their own currency. This could potentially lead to rapidly declining currency values and many of the problems associated with declining currency such as inflation, economic difficulties and others.

 

Perhaps the biggest reason that such a scenario may be unlikely in modern times is that today’s banking systems are very different from those of nearly a century ago. Central banks today have few limitations compared to back then, and have the ability to print money at will. A specific amount of gold is not required, for example, by countries engaged in quantitative easing programs.

 

While we must stress that anything is possible, it seems that the threat of confiscation today is extremely remote. The idea of confiscation is, unfortunately, commonly used by some precious metals dealers attempting to sell higher premium “collectable” coins to the unknowing public.

Precious Metals and Interest Rates

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Precious Metals and Interest Rates

Interest rates play a key role in today’s modern economy and monetary policy. The Federal Reserve can make changes to key interest rates and interest rate expectations and control the flow of capital into the economy. In other words, by maintaining low interest rates, capital is easier to acquire. This ease of acquiring capital can fuel economic growth as more money available translates into more potential spending. If too much capital becomes available, however, a situation may arise in which there is” too much money chasing too few goods.” This can lead to inflation due to the fact that as more capital looks to acquire fewer goods and services, those providers of goods and services can charge more money, hence rising prices.

 

Many central banks around the globe have held interest rates quite low for some time. The U.S., for example, has held rates at zero for several years now in order to spur economic growth. The U.S. is, however, getting ready to hike rates for the first time since June 2006. The topic of rising rates has been the subject of considerable discussion-and debate-and gold and precious metals have been mentioned considerably in those conversations.

 

Many investors seem to believe that the correlation between gold and interest rates, for example, is negative. While this does make some sense at first glance, the idea of this relationship can, in fact, be quite misleading. Looking back at gold over the last several years shows how low or negative real rates can drive the metal. Gold made its all time high back in 2011, as the Fed was engaged in a zero interest rate policy and was fighting the economic slowdown with massive amounts of bond purchases, or QE. Since that time, the metal has pulled back from this high, and currently sits around the $1200 level.

 

Some in the anti-gold crowd have suggested various reasons that the metal topped out when it did, such as improving economic conditions and the eventual end to the central bank’s QE program.

 

Many also suggest various arguments against holding gold, such as the fact that gold incurs storage costs and “does nothing” in terms of dividends or interest earnings. There is also the argument that gold will not perform well when interest rates do start to rise…

 

In Reality, however, gold can potentially perform well in both declining and increasing rate environments.

 

One of the major reasons for this possibility is the fact that as interest rates rise, there may potentially be an exodus from “risk assets” such as equities and bonds.  As investors move out of risk assets and into alternative asset classes, gold and precious metals may stand to benefit.

 

This scenario was seen back in the 1970s. Gold moved higher along with interest rates as stocks and bonds had a challenging time. From 1977 to 1980, interest rates skyrocketed from 4 percent to over 20 percent. Gold saw huge appreciation during this period, rising from less than $200 per ounce to over $800 per ounce.

 

Clearly, higher interest rates do not necessarily mean lower precious metals…

 

In the current global financial landscape, emerging markets such as China and India are responsible for a vast percentage of global gold demand. Because of this, rising interest rates in the U.S. will likely not have as much of an influence on the gold price as some anticipate.

 

Thus, Gold has shown that it can appreciate in value in both falling and rising rate environments.

 

As the global financial landscape changes, gold may potentially become more useful and important than ever. Stocks have been moving higher for years now, and could be showing signs of cracking.

 

China has been steadily taking steps to further cement its place among the world’s economic elite. These steps include buying large amounts of gold. The nation’s currency, the yuan, will likely be accepted as an alternative reserve currency, and could pose a serious challenge to the dollar as the global reserve currency of choice…

 

We believe that the notion of higher interest rates and correspondingly weaker gold is a fallacy. In fact, we feel that now is the opportune time to look at allocations in the precious metals complex, regardless of rising rates.

The Long-term Trend of Gold

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The Long-Term Trend of Gold

As a commodity, gold prices fluctuate. These fluctuations can be very minor and can at times appear to be more significant. Any financial news channel you may tune into, or any financial news website you may visit will likely have the current price of gold, silver and even other precious metals readily available.

 

The current price of gold can be affected by many different factors. Some of these factors include:

 

  • Central bank activity
  • Currency markets
  • Geopolitical events
  • Economic conditions

 

When looking at gold as an investment, we feel it is important to base such an investment on your objectives. For example, someone who wishes to invest in gold for a short-term move is “trading” gold rather than investing in gold.

 

It is very important to distinguish between “trading” and investing. Those who want to try to capitalize on short-term price fluctuations in gold-using technical analysis for example-are traders. Those who want to invest in gold for the long run are investors.

 

Gold investors are often not concerned with the day-to-day, week-to-week, or even year-to-year fluctuations in the gold price. They are often buying gold for the potential of an increase in value, but are also investing in gold for many other reasons. Some of these reasons may include:

 

  • To hedge potential inflation
  • To hedge currency risk
  • To provide peace of mind
  • To own a hard asset that is not tied to a central bank and carries no counterparty risk

 

Whatever the case may be, knowing where gold has come from and where it could potentially go may provide some peace of mind.

 

The long-term investor is likely only concerned with the “long-term” and therefore we felt it prudent to outline gold’s trend over a larger time period.

 

Mid Seventies: Gold traded for under $200 per ounce

 

Late Seventies: Gold prices began to climb, and climb rapidly. As inflation began to accelerate, gold prices accelerated along with it.

 

1980: The price of gold, already benefitting from high inflation, spiked to over $800 per ounce. Some believe that this parabolic move during this year was due to the Soviet invasion of Afghanistan.

 

1981: The price of gold settles down and prices move all the way back down to around $350 per ounce.

 

1982-2002: The next 20 year period saw gold essentially range bound. The metal fluctuated between about $500 per ounce on the high side and $250 per ounce on the low side.

 

2004/2005: Gold begins to find more buying interest, and prices eventually break above their highs of the last two decades. This could likely be attributed, at least partially, to the end of the tech boom, affectionately referred to as the “dot-com bubble” and corresponding bear market in equities.

 

2006-2011: Gold prices appreciate rapidly, moving almost straight up during this five year period until they hit their all time high of nearly $2000 per ounce. Gold’s rise may be attributed to massive central bank action including low interest rates and quantitative easing.

 

2011-Present: Gold prices have pulled back since making their 2011 high, and currently sit around the $1200 per ounce level. While the U.S. has ended its bond buying program of the last several years, many other nations, including Europe and China, are still actively engaged in QE or other economy-boosting measures.

 

There are a couple key elements we feel are of importance here.

 

Gold’s trend is clearly up: When looking at the yearly gold chart, the price is undeniably trending higher. Does this guarantee gold will resume its uptrend? No. It does mean, however, that for the patient long-term investor, gold at current levels may represent an excellent long-term buying opportunity.

 

Gold may potentially rise during periods of uncertainty: Looking at the price of gold over the last several decades, you can clearly see how gold sometimes reacts to uncertainty-whether it is economic, geopolitical or otherwise.

 

Gold’s pullback has corresponded with a bull market in equities: As gold has retreated from its all time high in recent years, stocks have done the opposite, making new all time highs themselves.

 

What this tells us is that:

 

  1. If gold resumes its uptrend, it has the potential to move significantly higher. Think $5000 per ounce gold sounds silly? Think again.
  2. Gold may provide a hedge against falling stocks and a number of other economic calamities. Think the current bull market in stocks will last forever?
  3. Gold may continue to rise because it is a commodity of limited supply. As fiat currencies depreciate over time, demand for hard assets like gold may rise, and potentially drive prices significantly higher from current levels.

 

We believe that all of the pieces are in place for gold and other precious metals to rise sharply over time. While price trends can and do change, we believe that gold will in fact resume its uptrend to much loftier levels based on simple supply and demand, paper currency depreciation and economic/geopolitical factors.

 

Why is Gold held by the Central Banks?

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Why is Gold held by the Central Banks?

If one has looked into the gold market in recent years, one will likely have read that central banks are net buyers of gold. After years of selling the yellow metal these powerful financial institutions are now buying gold and holding it. Central banks are the largest players in the gold market, and if they are buying gold there is likely good reason.

 

Central banks have a great deal of responsibility. These mammoth institutions are responsible for monetary policy in their respective nations. Some central banks may be responsible for monetary policy in a group of different nations, such as the European Central Bank.

 

The scope of a central bank’s duties does not end with monetary policy. These banks are also expected to monitor and encourage employment, keep currency values stable and control inflation. In addition, central banks act as the primary bank of governments and oversee and manage the bank reserve and credit systems.

 

In Canada, the central bank is the Bank of Canada. In the United States, the central bank is the Federal Reserve.

 

The Bank of Canada’s responsibilities fall into a few categories. Its principle role is “to promote the economic and financial welfare of Canada.”  The categories for the Bank of Canada are as follows:

 

  • Monetary Policy-controlling the money supply
  • Financial System- promotion of safe and efficient financial systems
  • Currency- Issuance of Canada’s bank notes
  • Funds Management- The bank manages Canada’s foreign exchange reserves and public debt while acting as the fiscal agent of Canada

 

The United States Federal Reserve also has several categories outlined. These categories include:

 

  • Production of price stability and employment
  • Systemic risk control
  • Supervision and regulation of banks and financial institutions
  • Provide financial services to the U.S. Government

 

Although central banks have been net buyers of gold in recent years, some have a lot more gold than others. The Bank of Canada’s gold reserves, for example, pale in comparison to that of the United States. It should be noted, however, that the U.S. Federal Reserve does not own the gold but rather the U.S. Treasury does.

 

Whether through a central bank or a treasury department, many sovereigns own physical gold.  There are many different reasons that these large financial institutions may own physical gold. Some of these reasons may include:

 

  • Desire for credibility
  • Desire for stability
  • Reserve diversification
  • Hedging purposes

 

Gold is symbolic of power, value, economic credibility and prestige. The yellow metal has been recognized a reliable store of value for thousands of years, and can be exchanged anywhere in the world without counterparty risk.

 

China and its recent gold buying activities are a great example of what gold ownership may accomplish. China has been buying large amounts of gold in recent years, and although they have not publicly stated their gold holdings, some estimates put their reserves from 3000-8000 tons. This gold acquisition is likely an attempt by Beijing to boost the credibility of its currency, the yuan. The yuan is on the verge of being accepted as a global reserve currency and part of the IMF’s Special Drawing Rights.

 

The yuan could, in time, challenge the dollar as the preferred global reserve currency. The more gold that China has in reserves, the more likely such a scenario could become due to the fact that gold is viewed as a relatively stable asset.

 

Because of its history, inherent value and relative stability, gold may potentially provide central banks with a means of reserve diversification as well as global credibility.

 

The Dollar as the Reserve Currency of the World

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The Dollar as the Reserve Currency of the World

The U.S. dollar has enjoyed its status as the global reserve currency of choice for some time now. Since the implementation of The Bretton Woods Agreement, the dollar has been considered the anchor of the global financial system. Under this agreement, the United States guaranteed other central banks that they could sell their dollar reserves for a fixed rate of gold.

 

In the 1960s and 1970s, some flaws were seen in this system, however. The Triffin Dilemma was first identified in the 60s by economist Robert Triffin who believed that a conflict of interests undermined the system. According to Triffin, this conflict arose out of differences in short-term domestic objectives and long-term international objectives.

 

Triffin also pointed out that the country who was supplying other countries with its currency for reserve purposes must be willing to supply enough of the currency to fulfill global demand, and this extra supply of currency leads to a trade deficit.

 

This dilemma is often cited as one of the most-if not the most-significant problems with the Bretton Woods Agreement.

 

This eventually led to a balance of payments dilemma as well. The U.S. had to run a balance of payments current account deficit to ensure enough liquidity for the conversion of gold into dollars. The influx of dollars led speculators to believe that perhaps the dollar had become overvalued.  As more dollars were converted for gold, it also meant that the country’s gold reserves were not as robust. Less gold in the country led to even more concern about the dollar’s value, and the country had to run a balance of payments current account surplus in order to boost the dollar. Needless to say, the country cannot run a balance of payments current account deficit and surplus simultaneously.

 

Clearly the system was flawed, and in 1971 then-President Richard Nixon initiated “Nixon shock” under which dollars could no longer be exchanged for gold. This was, in effect, the demise of the Bretton Woods System.

 

The Petrodollar

As confidence in the dollar was a concern, President Nixon negotiated a deal with Saudi Arabia for all future oil sales to be dollar denominated. In exchange, the U.S. would provide Saudi Arabia with protection for its vast oil fields. Other OPEC members also followed suit. These agreements ensured that demand for U.S. dollars would remain robust, and helped to support the dollar’s value.

 

While demand for dollars has been strong due to the fact that nations need dollars in order to transact oil, this agreement also likely boosted demand for U.S. debt in the form of treasuries. The dollar’s reserve currency status as well as demand for U.S. debt has been advantageous for the U.S., as it has kept interest rates down, although a stronger dollar can have negative effects on exporters.

 

The Dollar’s Future as the Global Reserve Currency of Choice

There has been much discussion over the years about the dollar’s status as the preferred reserve currency of the world. The currency markets appear to be currently undergoing some significant changes, and the dollar could potentially be challenged.

 

Several nations have already begun a move away from dollars. China, Russia, even France have all set up swap lines to facilitate transactions outside of U.S. dollars. Even some multinational corporations have also taken similar measures.

 

Some believe, in fact, that the only issue preventing a direct challenge to the dollar is the ongoing petrodollar system. If Saudi Arabia and other oil producers made a move away from dollars, it could potentially set the stage for massive dollar depreciation as capital could flow out of dollars and into other currencies, while demand for U.S. treasuries could also potentially see a dramatic decline. If many of these dollars found their way back home, the rapid increase in supply could severely undermine the value of the dollar and possibly lead to rapid inflation in the U.S. as well as rising interest rates.

 

The Yuan as the Next Preferred Reserve Currency

It’s no secret that China has taken steps in recent years to bolster its position both economically and politically. The country has also been reportedly buying massive amounts of gold, although the country’s exact holdings remain unknown. Some estimates put China’s gold reserves at 3000 tons while others believe the country could be holding 8000 tons.

 

Whatever the case may be, it is possible that China is looking to bolster its gold reserves in an attempt to gain more credibility for its currency, the yuan.

 

On October 20th of this year, the yuan is set to become a member of the International Monetary Fund’s (IMF) Special Drawing Rights. This would mean that the yuan is now accepted as a global reserve currency and could potentially be the first step in a direct challenge to the dollar.

 

While much of this may be pure speculation at this point, it would not be far-fetched to see even more countries moving away from dollars and into yuan.

 

China is the world’s second largest economy, and has been experiencing rapid growth in recent years. As China looks to further cement its place among the global elite, it will likely continue to push for additional acceptance of the yuan as a preferred global reserve currency.

 

While the dollar remains the global reserve currency of choice, the currency could potentially see outflows into a viable alternative such as the yuan.

 

Clearly, China believes that owning gold is important. Gold is symbolic of power and prestige, as well as financial stability. As uncertainty over the dollar’s future as the world’s reserve currency mounts, gold may see additional demand from other nations as well as smaller investors looking to hedge against currency risk.