This is the first of a three-part interview with Paul van Eeden (www.paulvaneeden.com) conducted on March 8, 2005 during the PDAC Conference. Paul, formerly Managing Editor for Doug Casey’s International Speculator and now the publisher of his own weekly stock alert service for high net worth investors, is one of the most original thinkers and analysts working in the resource business today. In the next installment, he discusses his skepticism on base metals plays and more… look for it.
Let’s start with gold. We’ve seen gold go up, we’ve seen the dollar bounce. Where are we now in the cycle?
PVE: A lot of people are calling for strength in the dollar this year and that’s probably due to the perception that rates might be going up. The Fed is talking about raising short-term rates. Some people anticipate a 50-basis-point rise. And the prediction is that if rates go up, the dollar gets stronger. For most of last year, I was writing articles saying that the next major rise in the gold price will not occur until the dollar falls in conjunction with rising interest rates. This is counter-intuitive to most people because usually when rates rise, the currency gets stronger. I’m saying, what will happen is that rates will rise and the currency is going to fall. And the next major rise in the U.S.-dollar gold price will not occur until that happens. We saw a little bit of that after the election – rates started rising, which means there was pressure on the bond market, and the currency was falling. I actually made a call on Kitco saying that the gold price was going to rise, and it did. But now we’re back into this environment where there’s a perception of higher rates and strength in the dollar.
And what would cause rising rates along with a falling dollar?
PVE: It has to do with the mechanism that drives the system. Central banks in Asia – specifically Japan, China, and South Korea – are sitting on probably close to a trillion U.S. dollars. Of the three, Korea has the smallest holdings at $60 billion. Japan has around $680 billion. And China has around $200 billion. A few weeks ago the dollar fell due to a line item in the Bank of Korea statement to the legislature saying that they’re re-examining their foreign reserves holdings. On the day that the press got hold of that, the dollar fell 2 percent against the Korean won, 1.4 percent against the yen and 1.4 percent against the euro. That was without any sale of dollars. Nothing. Just nervousness in the market.
And why was the market nervous?
PVE: To understand this, you have to step back and ask, why do these central banks have all those dollars in the first place? It has to do with the trade deficit. When Wal-Mart buys goods from a Chinese company, they pay in U.S. dollars. The Chinese manufacturing company deposits those dollars at their commercial bank in China. The Chinese commercial bank converts the dollars into renminbi at the central Bank of China. And the central bank would then, under normal circumstances, sell those dollars into the foreign exchange market for renminbi. So, if you have a trade where the United States imports goods from China, the money flows through the manufacturer, through the commercial bank, through the central bank and then ends up on the foreign exchange market where it’s putting pressure on the dollar. When a country imports goods, it puts downward pressure on its currency. That is a self-correcting mechanism; it’s how the free market works. You will not get the current run-away trade deficit with that mechanism because as the amount of importation gets bigger, there is more pressure on the dollar to go down.
So what’s happened recently to amass such a large deficit?
PVE: The Chinese don’t want the renminbi to rise against the dollar, which it would if you close this loop. When the Bank of China sells dollars in the market for renminbi, the dollar goes down, the renminbi goes up. But the Bank of China didn’t want the renminbi to go up, so they didn’t complete the loop.
What they did instead is bought U.S. Treasury bonds with those dollars. So, the dollars never went into the forex market. That’s why the trade deficit kept rising as the dollar stayed strong. That’s why China is sitting on $200 billion dollars. That’s why Japan has close to $700 billion dollars.
So, this wasn’t a direct decision on their part to amass a treasury of dollars? It was just a byproduct of trying to keep their currency low?
PVE: It’s not that they wanted all those dollars. They just didn’t want their own currency to change. China has an official peg of the renminbi against the dollar. You can’t just say, “Well, the renminbi is 6, and we’re not going to let it change.” You have to do something to not let it change. And the mechanism is you can’t sell your dollars into the foreign exchange market. That’s why southeast Asia is sitting on a trillion dollars.
Does the same reasoning apply to Japan?
PVE: Yes. Japan doesn’t have an official peg, but they didn’t want the yen to rise. Trade with Japan was much, much larger than trade with China – although I believe trade with China has now surpassed that with Japan. But over time, Japan has accumulated the dollars for exactly the same reasons. There’s enormous pressure on China to revalue the renminbi. The U.S. wants them to revalue it, and so does Europe. What does that mean? It means they want the renminbi to rise against the dollar. What does that mean? It means that China will not hold back as many trade dollars as they have in the past. So the loop will get closed. Trade dollars flowing into China, Japan and Korea will start entering the foreign exchange market. That doesn’t mean that any of those countries have to sell their existing holdings. It just means that they’ll stop hoarding as much as they are. But that puts immediate downward pressure on the U.S. dollar by virtue of the fact that we have such a large trade deficit. Remember, in the free market these things are self-correcting. All the stuff that we import will put pressure on the dollar, under normal circumstances. It’s only if you stop the flow that you get the imbalance. What the world is calling for now is for that imbalance to be taken away, and the fall to continue. Nobody talks about this because nobody wants to scare the beejezus out of the market.
But American politicians have been asking for China to remove the peg. Do they realize this is going to be bad for the dollar?
PVE: Some do and some don’t. It’s always tough to know what a politician really knows. But I’m convinced that some do. They must understand this. But the point is that if China revalues, the dollar goes down not just against the renminbi but also against the yen, the euro, and every other currency, because that’s the nature of the market. But there’s a second thing that happens. I said earlier that because they wanted to stop the flow of dollars into the foreign exchange market, they ended up holding a lot of dollars and they wanted to do something with them. And what they did was buy U.S. bonds. What happens when you go and buy a whole bunch of bonds? Bond prices go up. And interest rates and bond prices are inverted. If bond prices rise, interest rates fall. So, why do we have such low interest rates in the United States? Because all these bonds were being purchased with trade dollars that didn’t hit the foreign exchange market. If the trade dollars start hitting the forex market, then bond purchases from southeast Asia, especially China and Japan, will slow down. They in fact have started slowing down since April of 2004. If you look at purchases of U.S. Treasuries by China and Japan, they peaked in April 2004. But if China revalues and Japan allows the yen to float higher, which they will when China revalues, then bond purchases are going to diminish even further. Then what happens to interest rates? Interest rates rise at the same time that the dollar falls because it’s two sides of the same coin. And until that happens, the dollar is not going to sustain a meaningful decline, and hence the gold price in dollars will not sustain a meaningful rally.
But when people see interest rates rising while the dollar keeps falling, won’t there be a panic?
PVE: It doesn’t have to be panic. But that’s when you know that the rise in the gold price is sustainable.
Any sense of when we may see that happen?
PVE: No. I don’t know what the premier of China is going to decide. I don’t even know what my wife is going to decide to do tomorrow – how would I know about China? It’s impossible to predict timing on this thing. But given the amount of pressure on China to revalue, I wouldn’t be surprised if it happened this year. Now, that doesn’t mean we won’t see a rally in the dollar before the revaluation happens. It doesn’t mean we can’t see a drop in the gold price. But I think there’s a reasonably high probability that before the end of the year, China will decide to float or revalue, which means we could see a material rise in the gold price.
What sort of a rise would you expect?
PVE: Gold over $500 wouldn’t surprise me.
And is that a stepping stone to yet higher prices?
PVE: That is probably the stepping stone toward the revaluation of the U.S. dollar to the level where the cost of imports would rise sufficiently to start dampening the trade deficit. The mechanism will start correcting. I suspect the dollar could fall on the order of 20 to 30 percent against a basket of currencies. I’m not saying it will fall 20 percent against the euro or against any one currency. But on average I wouldn’t be surprised if it fell that much. And then gold will go to somewhere between $700 and $800 an ounce. And it doesn’t have to happen in six months. This is a process that’s going to happen over a number of years. But to me, this next step – a falling dollar and rising interest rates – will take the dollar down to its correct value and gold up to $700 or $800.
When all this occurs, there’s another thing that’s going to happen. The falling dollar will cause prices in the United States to rise. Because all the stuff that we import, including things like oil, will rise in price. And because we import so much, this general rise in prices will appear inflationary, at the same time that interest rates are rising. Higher interest rates in the U.S. will pop the real estate bubble, raise the cost of corporate borrowing, and therefore decrease corporate earnings. It will raise the cost of consumer borrowing and therefore reduce consumer spending. If you reduce consumer spending and you raise the borrowing costs for corporations, corporate earnings plummet and you get equity markets going down, bond markets going down, housing markets going down, which means you see a slow-down in U.S. economic activity. If you get a U.S. slow-down, China slows down because a lot of Chinese exports go to the U.S. European economic growth right now is anemic, so I suspect Europe slows down. And Japan probably slows down. So, we go into a worldwide economic downturn. And all of this happens at the same time – it’s all inter-mingled. So you see the downturn in the economy at the same time as the gold price rises from $440 to, say, $800, and it’s not unlikely that we’ll see an emotional reaction akin to what we saw in the late seventies. In 1978 and ‘79, the gold price essentially doubled, but it was an emotional reaction to events of the time. The gold price had no business being at $850 in January 1980, which is why it collapsed afterward. We’ll see the same thing happen again, except that this time gold has business being in the $800 range. But if we see all these events unfold and we get an emotional reaction with people buying gold out of fear, the gold price rises rapidly and then they start buying gold out of greed and it’s not unlikely that we can see gold breach $1000, and who knows how high it will go? $1000, $2000, I don’t know. Regardless of what it is, once you enter that emotional phase, you have to get out. That’s when you cash out. Because after that emotional run-up, there will be a correction.
To the $700 or $800 level?
PVE: Or lower. The market is always volatile – it always trades above and below fair value. I suspect this market will be no different. By the time we reach fair value, we’ll probably run past and exceed it, just to turn around and drop down below it.
Paul van Eeden is well-known for his research on the gold market and mineral exploration companies. He is a regular speaker at several international conferences and frequently appears as a guest on numerous radio and television shows. He writes a weekly column on Kitco and a weekly newsletter talking about his own investments. For more information and to subscribe please visit: www.paulvaneeden.com.