Gold and the Dollar in a Flip-Flop

By Christopher Byron

A "Reagan euphoria "and high interest rates spur a surprise

During the past four years the American dollar has sagged deeper and deeper, while the price of gold tended to soar higher and higher. In the past two weeks it has been the other way round. Gold has lurched lower, as the dollar has risen.

The effect of this role reversal has been to discombobulate money markets everywhere, and last week the turmoil intensified. In Frankfurt, the deutsche mark slumped to a three-year low of 2.16 to the dollar, forcing the West German Bundesbank and the U.S. Federal Reserve into an unusual rescue mission of the mark. The two central banks each sold $500 million in dollars at midweek to prop up the weakening West German currency. In Zurich, the Swiss franc dropped into a two-year trough of 1.95 to the dollar, and in Milan the Italian lira plunged to a record low of 1,019 against the dollar. At the same time, the declining value of gold pushed bullion to $500.50 an ounce at week's end, or a little more than half the all time peak of $850 an ounce reached one year ago.

The renewed volatility in currency values was unsettling because such gyrations make it difficult for international businessmen to negotiate a loan or sales contract, or even to project the cost of a company payroll. The bulk of international transactions is made in dollars, and an unstable currency makes all planning difficult. Moreover, some experts wondered if the new situation of a strengthening dollar would quickly be followed by a weakening of the U.S. currency. But Italian Economist Luigi Spaventa challenges this view, arguing: "The underlying causes appear to be far stronger than in previous cycles of the dollar."

At least some of the dollar's appeal and gold's weakness is coming from what European bankers are calling the "Reagan euphoria." Just as the value of the dollar fell because world moneymen did not believe that Jimmy Carter was serious about battling inflation, it is now rising because the new Administration looks more determined. Said Beryl Sprinkel, the Under Secretary of the Treasury-designate for Monetary Affairs: "We're getting on top of this inflation problem, and the markets are beginning to believe it."

Much of the dollar's recent strength is attributable to something the President has little direct control over: steep interest rates. At present levels of 17.5% for three-month deposits, American banks are paying interest rates far above the U.S.'s 13% inflation rate. The interest rate in West Germany is only around 9%, while in Japan it is about 8%. The high level of real return attracts many international investors to deposit their money in the U.S., thus strengthening the value of the dollar.

Demand for dollars has also been strong because some holders of gold are selling the metal out of fear that it now faces a long slide. The U.S. Treasury estimates that 14,000 to 16,000 tons of gold, worth about $240 billion at current prices, are in private hands worldwide. If the goldbugs dump only a small portion of their holdings and buy dollars, that transaction can have a very large impact on both the price of gold and the value of the American currency.

At the same time, high American interest rates have flattened the gold futures market. Speculators buy and sell the futures contracts for the delivery of gold in three-or six-months' time in hopes of profiting from the rising price. In contrast to the spot market, where only about 50 to 60 tons of gold bars or coins are traded daily, three times as much is bought and sold in the form of futures contracts. When interest rates climbed last autumn, speculators borrowed heavily from commodities brokers and banks to buy gold futures, believing that once interest rates peaked they would plunge quickly, as happened last spring. That would have sent gold still higher and hammered the dollar. Interest rates did peak in January, but they are now dropping far more slowly than expected. Many speculators have been unable to finance their loans and are being forced to sell futures contracts at a loss, which drives the price down further.

Gold market experts also say that the end of the hostage crisis in Iran is helping to depress the cost of gold. Explains a senior gold trader at a leading New York bank: "In a sense, the gold market has become almost like a drug addict, needing more and more of a bad-news fix to get high." Recently there has just not been enough bad news to keep the market up.

The currency confusion is being aggravated by a host of local problems. West Germany's deutsche mark is suffering from both a strong dollar and a West German economy that is slipping into recession. Moreover, the Bonn government and West German banks are major lenders to Poland and would lose upward of $5 billion if that economically troubled nation defaulted on its loans. In this world turned upside down, the two strongest currencies are the Japanese yen and the British pound. Both have risen dramatically against the DM as well as the dollar, but for different reasons. With 2% unemployment, 6.9% inflation and projected growth of 5.3% in 1981, Japan's economy is far and away the industrial world's healthiest. Bankers believe that in view of this, the yen will continue to climb in value as 1981 progresses.

By contrast, the slumping British economy is in terrible shape. Unemployment is now 8.8%, and the British gross national product is expected to decline by 2% this year. Yet sales of North Sea oil have cut British dependence on imported crude, pushed the nation's balance of payments into the black, and kept the pound strong on international money markets. In fact, the British government has become concerned that its currency is too strong, and last week Prime Minister Margaret Thatcher said that the value of the pound should decline.

In a world of nervous money, the dollar's new strength and gold's weakness could pass quickly. If the world's moneymen decide that the Reagan Administration's inflation policy is too weak or that it will be killed in Congress, the recent currency adjustments might change again. Said Mohammed Ali Abalkhail, the Saudi Arabian Finance Minister, last week: "We are still looking for clearer indication of what policy Reagan will really follow. That will determine whether the current surge in the dollar is a temporary phenomenon. " -- By Christopher Byron.

Reported by Frederick Ungeheuer/New York and Bruce van Voorst/Brussels

With reporting by Frederick Ungeheuer, BRUCE VAN VOORST

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