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October 27, 2004
Dollar Adjustments And The Golden Rule

Last weeks COT data on gold revealed a net decline in speculative (nonreportable) long interest and a net increase in commercial short interest. Given that the COT statistics are current only as of October 19 – when gold was trading around $420 an ounce - the data is not tremendously useful.  Even so, leading into this week the data did give animal spirits something to cheer about: for steadfast bulls the decline in speculative long interest suggested that the current rally had not reached a ‘follow the herd’ type top, and for steadfast bears the increase in commercial short interest suggested that a top is drawing closer.

Net commercial short interest as a percentage of open interest (futures and options) remained above 40% for the third week in a row. The last and only other time (since the data was archived in 1995) this figure stayed above 40% for 3-weeks in a row was between March 30, 2004 and April 12, 2004. During the March-April streak the commercials were adding to their net short stake as the price of gold peaked and then crashed.  By contrast, today the commercials are adding to their net short stake as gold rallies strongly.

The growing commercial short position begs one question: are the commercials going to lose BIG as gold continues to skyrocket?  The deciding factor will undoubtedly be the near term direction of the U.S. dollar. 

U.S. Dollar Woes Deepen

Before rebounding yesterday the U.S. dollar had declined for nine sessions in a row – the dollar’s longest losing streak since December 2000. Two of the most popular reasons for the dollar’s latest decline are said to be record oil and uncertainty surrounding next weeks U.S. election. However, before blaming oil and the elections for all that ails the dollar it should be remembered that the last time the U.S. dollar index was trading at current levels crude was at $35 a barrel and the U.S. elections were 9 months away.

Suffice to say, CNBC sound bites and AP one liners from Wall Street analysts do not explain why the dollar is resuming its decline.  Rather, long-term astute dollar bears like Stephen Roach do.  Roach currently believes that the dollar’s decline is just beginning and that no post-election dollar rally looms.  Moreover, Roach understands that oil is used by countries other than the United States. Thus, he correctly frames his oil opinions under the ‘global economy’ banner, and does not draw direct correlations between oil and the dollar.  In short, Roach believes the dollar’s decline is all about correcting a massive imbalance:

“In my view, this move in the dollar is a “drop in the bucket” for a US economy with a 5.7% current account deficit that could easily climb in the 6.5% to 7.0% zone in the next year… In the end, this [intervention] is a losing game.   Intervention cannot neutralize the deadweight of America’s massive current-account deficit.  That’s the message to take from the recent fragility of the strong dollar.  For what it’s worth, I suspect that the dollar’s slide will accelerate sharply in the aftermath of the US presidential election…”

The mammoth/unsustainable U.S. current account deficit makes agreeing with Roach easy. Indeed, even the Wall Street partly line – ‘oil and the elections hurt the dollar’ – has started to include ‘current account deficit fears’ into their subtext. 

But with the dollar falling and the bandwagon filling up is there a risk that agreeing with Roach and others has become too easy?  Perhaps so, at least in the near term.

COT Gold Statistics Suggest that a Dollar Rebound is Near

Although few would draw this correlation, it should nonetheless be made: by adding to their net short position as gold rallies the commercials continue to indirectly bet that a U.S. dollar rebound [gold price decline] is near.  In the context of ‘gold is money’ this is the one dollar positive that eludes almost any discussion.  Rather, the vast majority of analysts conclude, correctly so, that the dollar leads gold and not vice versa.

Incidentally, the commercials adding to their short position has the potential to be a ‘dollar positive’ because the commercials always win.  In order for the commercials to profit from a falling gold price the logical conclusion is that the dollar must rebound.

Rather than belabor the point one question will suffice: at what point does a declining dollar become a major risk to the financial health of commercial gold shorts? No one is entirely sure. Nevertheless, failing a dollar rebound the commercial short position appears set to reach unmatched proportions; failing a dollar rebound there is the potential for an unmatched rally in gold if the commercials ever admit defeat and/or default.

At what point do central banks(ers) make a desperate effort to save the dollar?

The most interesting issue Roach highlighted earlier this week wasn’t that the dollar’s decline is just beginning, but that the dollar’s decline may be beginning as planned:

“…in recent weeks, I have felt less lonely, as the official community — both in the US and around the world — has come out in the open in expressing concerns about America’s gaping twin deficits and what they mean for the dollar.  Fedspeak has been especially focused on this issue, with at least five Federal Reserve governors and regional bank presidents weighing in on this key risk.  I don’t believe in conspiracy theories, but I don’t think this collective expression of concern is an accident.”

The point Roach makes should not be overlooked.  To be sure, and despite Treasury Secretary Snow’s lonely ‘strong dollar’ regurgitations, very few policy makers and economists are even beginning to suggest that the dollar’s decline is overdone.  Rather, with the exception of the BOJ threatening intervention again, U.S. policy makers and foreign central banks have become more accepting of the dollars decline.  In other words, we are no where near the point of panic/crisis with regards to the dollar.

Conclusions

If recent history is any guide, a further decline in the dollar will compel the BOJ intervene in the FX market (to support the dollar). Moreover, and if ancient history is any guide, any serious collapse in the dollar will compel U.S. policy makers to change/sharpen their dollar rhetoric in an attempt to tell  traders that the dollar’s decline is overdone.  Only when these and other intervention/policy rhetoric actions occur will things get interesting.  As it stands now, the dollar’s decline has been organized and without incident.

The reason why the BOJ has not acted and U.S. policy makers are, for the most part, silent on the dollar is abundantly clear: the world has come to recognize that a falling U.S. dollar is a necessary evil.  Indeed, this is why Greenspan and company dare not even suggest that the dollar’s demise is ‘transitory’.

As for gold, the commercial shorts usually don’t retreat without profits.  Those that predict the commercials will be “overrun for the first time” should – to be perfectly blunt – have their heads examined.  Even the usually confident ‘Butler’ is saying he doesn’t know what will happen next.

At the time of this writing there is a lull in the action – the dollar index is holding above 85 (triple bottom) and gold is battling above 425.  Longer term Roach, Soros, Buffett, Fleck, and many others are on the money – the dollar will decline! Nevertheless, what happens in the near term may partially depend on if the lull in the gold market can be broken.  Mr. Greenspan can’t have his dollar adjustment if it means skyrocketing gold, can he?

In sum, the golden rule is that gold commercials do not lose BIG until the gold commercials lose BIG. Expect a drop in gold and a rebound in the dollar in the near term if you are logical. Expect $500+ an ounce gold if you think the dollar’s decline is about to go from necessary evil to cruel commercial punishment.