Buy gold to hedge US dollar downside risk (page 1 of 2)

Tight money policies, which would depress asset prices such as stocks and home prices is simply not an option the Fed will consider. As a result, inflation will continue, whereby I am using here inflation as defined by a loss of the purchasing power of paper money.

At times, such as in the 1970s, this loss of purchasing power of money is brought about by rapidly rising consumer prices, while at other times, such as in recent years, the purchasing power of money diminishes because real estate, stock, art and bond prices increase significantly. In both cases, under consumer price or asset price inflation, your dollar today can only buy a fraction of what it bought ten or twenty years ago.

What is remarkable is that for as long as there was no Federal Reserve Board - that is between 1800 and 1913, the purchasing power of the dollar was more or less constant. However, as soon as the Fed was formed in
1913, the purchasing power began to decline - in fact by 92% over the last 100 years or so.

Now, considering that Household Net Worth is at an all time high and that rising home, and equity prices in the last twenty years or so drove the US economy up and the household saving rate down (now negative), Mr. Bernanke will under no circumstance allow asset prices to decline much.

Just imagine what the Fed's reaction would be if both the Dow Jones and housing prices dropped by 10%! Money printing would be back in earnest because the Fed believes (erroneously, I may add) that it has the power to indefinitely postpone recessionary periods.

Now, if the Fed prints money, all asset prices will rise in nominal terms whereby some prices will rise more than others, while the currency of the money printing country - the US - will weaken. The only problem for us investors is to recognize and forecast, which prices will increase the most, consumer prices or asset prices, and if asset price inflation continues, as occurred in the past twenty years, specifically which asset prices will move up the most. Moreover, if the US dollar weakens it is important to define against what the dollar will depreciate.

Hedging dollar decline

The importance of being invested in the 'right asset class' is evident from the diverging performance of the Hang Seng Index or of Hong Kong property prices and oil since 1997. So, whereas the Hang Seng Index and Hong Kong property prices have not risen, since 1997, crude oil is up by more than four times! I would expect similar diverging performances among different asset classes to emerge in future as well.

In particular, I am a believer that at some point in future, investors will lose faith in the value of US dollar denominated bonds and in the US dollar. At such time, investors will drive US interest rates much higher resulting in tumbling bond prices and rush into anything but US assets such as equities and bonds.

This does not mean that all US dollar assets will collapse in nominal terms, but they could collapse against a 'hard currency' such as gold or possibly against non-US dollar currencies, provided foreign central banks pursue tighter monetary policies than the US. This, however, is an issue about which we cannot really be certain, as all central bankers have a propensity 'to print money'. Therefore, I feel that asset prices will tend to depreciate against the only currencies for which the supply is limited - gold, silver, and platinum.

I have shown the Dow/Gold ratio in the past but would like to expand on this theme.