Demise of the Dollar – How Fast Must It Happen Before People Begin to Notice?

October 14, 2010

Since the first week of June, 2010 the US Dollar Index (USDX) has dropped from 88.3 to 76.7. Well, what does that mean, you say? It means that the dollar has lost 11.6% of its value in just over four months. Compared to what you say? Compared to a basket of international currencies which are all declining. So what does that tell us? Not much, not much at all.

To get a better idea of the actual decline of the dollar’s purchasing power over the same period, let's look at the dollar price of gold:

June 3, 2010 spot gold on the NYBOT closed at $1205.80
October 14, 2010 spot gold on the NYBOT closed at $1379.50

Over that same period of time, gold has appreciated 14.4% measured in US dollars. Or more accurately, the dollar has depreciated 14.4% measured in gold. Hence the dollar has lost more than 14% of its purchasing power compared to gold in a little more than four months.

And why did gold appreciate over this period of time? The SUPPLY fundamentals of gold are as constant as the flow of the Mississippi River. Freshly mined gold supplies increase the world supply consistently by 2% to 3% annually, year after year like clockwork. The two other main sources of supply are: scrap gold recovery and central bank sales. Have you seen the television ads for companies like Cash4Gold.com? Mail us your old gold jewelry and we’ll pay you whatever the hell we think it’s worth! Imagine the brilliant people who fall for that one. Now if the dollar price of gold doubled tomorrow, do you think that the flow of scrap gold to these companies would double? Doubtful. Maybe at first it would, but the scrap supply to the market is limited and would eventually have to drop off.

Another traditional source of supply has been from central bank reserves. In 2009, the world’s central banks became net buyers of gold bullion after 19 straight years of being net sellers. My not so bold prediction is that we will see this trend continue indefinitely. The central banks are not fool enough to exchange a finite, and appreciating asset, gold, for one that is inflating towards infinity: the US dollar.

In May 1999 Gordon Brown chose to sell well over half the UK's national gold reserves, over 415 tons, at what turned out to be rock bottom prices.

Since the early 1980’s central banks around the world have consistently sold bullion into the market to contain the gold price (support the currency price), but by now they surely must be running low on physical reserves, and the immediate losses they would be facing by continuing to sell gold into the market now would just be too large. So forget about central bankers as a continuing source of supply in the future.

The fact is that the current production of newly mined gold is strictly limited. Existing mines are mining lower and lower grades of ore as time goes on. Currently, the average mine has to dig up 40 tons of gold ore, grind it to the consistency of sand, and extract it with toxic chemicals in order to produce one single ounce of pure gold. Add in the expense of petroleum used in production, rising labor costs, geopolitical costs to mine foreign sources, and the cost of minting the coin, and you can clearly see where the future price of gold is going, INDEPENDENT of the rapid and continual dilution of the currency by central bankers around the world (thank you Ben Bernanke).

What if you struck gold on your property today? Oh, lucky day! What is that average length of time from a gold strike to the time the mine produces its first ounce of gold ore? Ten years. Ten years of money invested before it begins to produce any income at all. Ten years of money going out, nothing coming in.

The other two main sources of gold supply, scrap recovery and central bank sales, both involve gold that was mined in the past, so by definition are limited.

What about gold’s DEMAND fundamentals, you say? Well, jewelry demand tends to fluctuate a bit. Industrial demand has always been minimal, and with the global economic recession it has declined, and should continue to decline for years. Investment demand has been steadily increasing for years as uncertainty and fear of inflation (well founded) continue to drive up purchases of coins and bars. Regular shortages of blanks at the mints have been causing supply disruptions over the last few years. Just ask your local coin dealer.

Think you're going to retire on your savings in dollar denominated investments? Think again.
Gold has appreciated 17% a year against the dollar on average over the past decade. Which means that the dollar has depreciated 17% a year on average in real terms. Is your IRA or 401K increasing by 17% a year, EVEN INCLUDING YOUR ANNUAL CONTRIBUTIONS? I don’t think so.

Think you’re going to collect on your pension? Well you might. Let’s think about it. Most pension funds have modeled their payouts on an 8% annual return on investment. Where can one currently get such a yield? Nowhere I can think of with any degree of safety. Most pension funds are heavily invested in bonds, especially US Treasuries. As the Treasury Bonds they are currently holding mature, they might want to reinvest that money into more Treasuries so it doesn’t sit idly by on their balance sheets with a zero return. Currently the 30 year US Treasury Bond is paying about a 3.8% yield. Why would anyone in their right mind tie up their money for thirty years at that pathetic yield when the dollar is vaporizing right before their eyes? And if your pension fund was foolish enough to do so, it would be taking in less than half the amount needed to continue payouts to its pensioners.

Also, with bond prices at record highs and interest rates at record lows, the risk of principal loss of 50% or more overnight as market forces inevitably drive interest rates up gives bonds a very poor risk/reward ratio as an investment.

What about municipal bonds, agency bonds (Fannie Mae, Freddie Mac, Ginnie Mae debt), or corporate bonds? They pay a slightly higher return, with a far greater risk of default.

Interestingly enough, some high quality blue chips such as Proctor & Gamble or Johnson & Johnson have started selling corporate bonds with lower coupons (interest rates) than US Treasuries of comparable maturity. What does that signify, you ask? Just that the US government now has to pay more to borrow than certain private companies. How could that be, you ask? Well, it’s because shrewd bond investors have identified the US Government as a worse risk to lend their money to than these blue chip companies. And with good reason. The government produces nothing, tax revenues are declining and will continue to decline as the population ages, and the government is already insolvent EVEN WITHOUT the incredible, unsustainable burden of social insecurity, medicareless, and medicbandaid.

Think that your pension fund has stock pickers good enough to produce a consistent 8% annual return in today’s stock markets? Well, maybe, if they are good at short selling, a highly risky practice with an unlimited potential downside, hence not employed by the vast majority of pension funds.

The truth is that most pension funds buy whatever investments their broker recommends (sucker bets). Lots of them have already lost huge amounts of their company’s employee’s money in mortgage backed securities, and other risky derivatives that they didn’t even understand, based solely on their broker’s recommendations. The country of Iceland already went broke buying these. Let’s hope that your pension fund administrator is better at investing than the country of Iceland’s financial advisors.

Unfortunately, the sad truth is that even if you DO manage to collect on social insecurity and your hard earned pension, at the rate that the dollar is being devalued, intentionally and continually, by the federal reserve, the money you’d end up with won’t buy you diddly squat by the time you can finally collect. You’d be far better off liquidating that IRA or 401K today, paying the tax penalty and putting what’s left into gold bullion at today’s price. They can’t PRINT any more of that. The most conservative investment advisors say to put 5% to 10% of your net worth into precious metals. I would say, conservatively, you would be better off putting 100% of the money that you don’t plan to spend over the next 5 to 10 years into physical gold and silver bullion, take possession, and sit on it.