Recent weakness in the US dollar during the past month has seen gold soar to new record highs. American gold buyers have been content to sit on their hands this week, having seen the metal stack on an 11% gain since the beginning of August. Their lucky counterparts down under have less concern for downside risk with recent Aussie dollar strength weighing heavily on the Aussie dollar gold price. Australian investors considering buying gold are offered some comfort in adding to their positions with established support in close proximity.

The Aussie dollar chalked up big gains in September, climbing 8% against the USD and reaching parity with the Canadian dollar. Many analysts are now looking beyond USD parity, although readers will recall these same predictions were short lived back in 2008. The credit crisis saw large scale liquidation of the carry trade and a sharp sell-off in commodity prices which chopped the Aussie dollar off at the knees.  The strength in our local currency is driven by expectation of future demand for commodity exports, confirming that the Aussie dollar is riding high on the belief that global growth will remain strong. Australian gold bullion investors should pay close attention to Asia and the global growth story, since another slump will be accompanied by a falling Aussie dollar and a move up in the Aussie dollar gold price.

Heralded as the new engine for global growth, the Asian region provided a cushion for the Australian economy during the credit crisis. Australia's export market is heavily weighted toward China (21.81%) and Japan (19.19%), with minerals and energy accounting for 37.6% of total exports. ABARE has forecast export earnings for mineral and energy commodities to increase by 28.4% to around $169.8 billion in 2010–11, giving credence to recent Aussie dollar strength. The big question is whether this rapid rebound in Asia is a new leg up in the commodities bull market, or merely the sugar high from excessive US and Chinese stimulus which precedes the next global economic meltdown. We put the spotlight on our two biggest export partners, China and Japan, as a proxy for future strength in the Aussie dollar.

China

As the global economy ground to a halt during the credit crisis, Chinese authorities moved to counter the slump with a stimulus package of ¥4 trillion (US$ 586 billion) and called for Chinese banks to extend credit to support the economy. Chinese banks opened the floodgates with new lending in 2009, resulting in the money supply expanding by around 30%.

This rapid expansion of bank credit in 2009 was successful in pulling Chinese GDP and CPI figures out of a swan dive. However, Chinese officials became concerned about an overheating economy earlier this year and moved to curb bank lending by increasing reserve ratios. Money supply growth has now been reined in to approx 18% YOY. While China can potentially deploy trillions in foreign exchange reserves and use Keynesian policy to prop up their economy, there seems to be a growing realisation that this will only magnify the problem of overcapacity. The automobile sector, steel, semiconductors, cement and aluminium are all showing signs of having too much capacity.

The Chinese economic model relies heavily on Western nation’s capacity to consume Chinese goods in increasing volumes. Household consumption in China makes up only 35% of GDP, compared to 70% in the US, confirming the theory of Chinese ‘decoupling’ is deeply flawed. With a median household income of $3000pa, Chinese citizens are far from having acquired the wealth to consume their own production as demand from Europe and the US continues to weaken.

Another significant concern facing the Chinese economy is the potential economic disruption caused by a revaluation of the Chinese Yuan. Chinese authorities have flagged their intention to gradually reform the Yuan exchange rate mechanism, but a hostile move from the US should not be ruled out.

The US House of Representatives passed legislation this past week, allowing, but not requiring, the US to levy tariffs on countries who undervalue their currency – no need to mention any names! A sudden appreciation in the value of the Yuan could potentially set off a chain reaction of factory closures and layoffs across the coastal cities which drive China’s export-oriented economy. It’s no secret that China’s property market is showing signs of overheating. An appreciating Yuan could well become the pin that pops the bubble.

Japan

Keynesian economists argue that Japan’s debt problems are old news – “If they were going to default, it would have happened by now.” While we acknowledge that Japan has endured a fiscal dilemma for the best part of two decades without collapsing, their structural problems have now deteriorated past the point of no return. The rising yen has crippled Japanese exports, causing a fall in tax revenues (now approx ¥38 trillion) while spending is again on the rise (approx ¥90 trillion). The difference will be covered by issuance of approx ¥52 trillion worth of Japanese Government Bonds this year alone.

Japan’s public debt of approx ¥930 trillion now stands close to 200% of GDP. The fact that 95% of the debt is held domestically is advantageous, but the personal savings rate is now below 2% and corporate savings are around 4%, suggesting that it’s not likely Japanese Government Bonds will continue to find local buyers. With US Treasury yields not far above JGBs, foreign buyers view JGBs as the ideal place to park capital in the short-term given the lack of inflation and a rising yen. The problem arises when investors begin to snub JGBs, as tax revenues continue their plunge and public debt balloons further. In 2009, 48% of Japan’s tax revenue was required for debt servicing. This year, 60% of tax revenue is required for debt servicing and borrowing costs are below 2%! As you can see, a rising yen is fuel on the fire for Japan’s structural deficit problems. Japanese authorities are desperate to put an end to the yen’s strength, recently selling ¥ 2.125 trillion in currency market interventions in September. However, since a rising yen was the primary reason foreigners were willing to hold JGBs at such low rates, it is doubtful they will be content earning a pittance on a currency being intentionally devalued. We are of the opinion that Japan is entering the twilight of entropy. It won’t be long before they hit the wall.

Conclusion

It is clear that commodity prices, Australian exports and the Aussie dollar have all bounced back strongly on the back of Asia’s reported ‘unstoppable appetite of growth’.  The inflationary monetary policy and media jawboning have become beer goggles through which economic matters are reported.  Even with this understanding, we cannot be confident calling a near term sell-off in the Aussie Dollar since the financial system is now largely controlled by human factors. Equity markets are temporarily being propped up by interventions such as the Fed’s Permanent Open Market Operations. This support is a powerful springboard for the Aussie dollar which could remain in place for some months. We can be confident, however, that fundamental economic conditions in China, Japan and the rest of the world will inevitably come home to roost. Without additional liquidity, we are likely to see equity markets retreat and the Aussie dollar decline, bringing nice profits to Australian gold bullion investors who continue to buy gold at AUDUSD parity. While we are clearly in the inflation camp in the longer term, we believe the long leg of the carry trade is looking crowded, just as it was before the 2008 deleveraging took Aussie dollar gold to all time highs.

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