Here's how I think various world markets will look in December 1979:
• The Federal Reserve discount rate, now in the 7-8 percent range, has fallen substantially from its record high of plus-11 percent in the first half of 1979.
• Similarly, gold, which peaked at $340 per ounce, is in a new bear market.
• Market action is now in stocks and bonds. The Dow Jones index is establishing new records almost daily, and traders who purchased long-term government bonds when interest rates were high have already made substantial profits.
• The year ended on a positive note for the American economy with the US dollar making solid gains against the Swiss franc, Deutschemark and Japanese yen. Indeed, 1979, at least the latter half, could be termed "the year of the dollar."
Predicting the collapse of gold and the rise of the US dollar is not something that will endear me to many gold/hard-money bugs. Yet every dollar has its day, however brief, and all good things must come to an end, if only temporarily.
The best way to lose money in markets is to become emotionally attached to one's investments. This is precisely what happened to gold bugs in 1974. Roaring inflation and the rise of gold justified the hard-money analysis that only gold is money and the US dollar is fated to an inevitable collapse. That analysis is even truer today than it was in 1974.
The rise of gold and the decline of the US dollar is not a straight-line affair, however. In 1974, the higher gold got, the higher were the predictions of how far gold would go. In my opinion, those people who then predicted gold at $1,000 or $1,500 per ounce will be proved right sometime in the future. Such advice, however, is valueless if it ignores the market fluctuations that will occur in the meantime.
My first rule of markets is, Everything that goes up must come down; my second rule, Everything that goes down must come up. Keeping those two rules in mind will not, of course, answer the questions When? and How far? But they will keep you from thinking that gold can only go up and the US dollar can only go down.
The US dollar is probably the most volatile commodity traded in the world. The reason is twofold: first, the dollar is the currency of world trade and world finance and is still the premier reserve currency held by central banks; second, the Eurodollar market is the tail that wags the dog. Approximately one-third of the dollars in existence are held outside the United States. Only a small proportion of these dollars need to change hands to create a substantial movement in the international value of the US dollar, either up or down.
The fact about the Eurodollar market that most people ignore is the nature of the owners of Eurodollars. They are financially sophisticated people, willing and able to switch into or out of dollars—or Swiss francs, or sterling, or gold—at a moment's notice. No other currency in the world has such a high proportion of its issue—about one third—held by such owners.
The other two-thirds of US dollars in circulation are owned by "average Americans," most of whom wouldn't know a Swiss franc from a Mexican peso. In the case of other currencies, probably 90-95 percent of the currency on issue is held by such average people who lack financial awareness.
In September 1977, some Arab investors (private individuals, not governments) switched out of dollars into gold and other currencies. Their movement was small relative to US dollars on issue, or in the Euromarkets: about $1 billion. But that movement sparked off a decline of the US dollar that is still in progress now. Even though the economic fundamentals of the US dollar—the inflation rate and the balance-of-payments deficit—are still negative and will probably continue to be negative through 1979, the current exchange rate of the dollar into Swiss francs, yen, Deutschemarks, and other European currencies is "undervalued."
This means that economic forces are at work that will favor the US dollar's value. For example, US exports have become cheaper on world markets while importing into the US has become less profitable. We've also seen an acceleration of foreigners' investment in the United States. To a small extent, this investment has been on the stock market. More important have been foreign takeovers, purchases of real estate, and the establishment of foreign-owned plants in the United States.
The decline of the dollar is having the reverse effect on economies such as the Swiss and Japanese. Though on balance a strong currency is beneficial to a country (see "The Strong Get Stronger," Money, April 1978), this is not to say that strong-money countries will remain unscathed if the US dollar decline is "too far, too fast."
Another important factor is US interest rates. They are currently rising and will continue to rise until the Federal Reserve discount rate is well over 10 percent. Just as inevitably, interest rates will fall. When they do, US stock markets will begin another bull market phase that should take the Dow Jones well over 1,100, and enormous profits will be made in government bonds. Already, looking from Zurich, Munich, or Tokyo, US stocks are considered very cheap. And what, after all, does a Swiss do with his money? Put it in a Swiss bank? No, he looks for more profitable opportunities—in Swiss franc terms, of course!
A combination of falling US interest rates, which will lead to a bull market in stocks and bonds, plus the effect of fundamental forces that will place a bottom on the US dollar, will lead to a substantial flow of foreign money into New York.
As I mentioned, a small shift of Euromoney into or out of dollars has a substantial effect on the exchange rate of the US dollar. If foreigners expect the Dow Jones to rise and if, at the same time, the US dollar has reached a bottom, the subsequent flood of money into New York financial markets will reverse the US dollar decline. A rising US dollar will bring substantial relief to many European and Middle East governments. The Eurodollar tail will wag the dog in the other direction.
All this will, of course, affect gold, precious metals, the Swiss franc, and other hard monies. They will all decline in US dollar terms. 1979 will be a time to take profits in those areas.
Just as fluctuations in the US dollar were wild in the downward direction, they could be equally wild upward. And, since there is no reason to expect the fundamental long-term weakness of the US dollar to change, this US dollar strength should be reasonably short-lived. From 12 to 18 months after interest rates have peaked, we'll be able to apply this analysis in the reverse direction—to predict the renewed decline of the dollar toward its long-term destruction.