Buy Canadian gold stocks to hedge U.S. dollar

by Levi Folk | December 18, 2006

Writing in Grant’s Interest Rate Observer, Jim Grant notes that "gold is a hedge not so much against disaster as against the fallibility of the creature called Homo economicus."

The hedge to consider for holding gold is one against a weak U.S. dollar. Investors should hold gold stocks in proportion to the amount of money they have invested in the U.S. equity and bond markets to avoid losing money on the currency over the long term.

The U.S. dollar has been stumbling recently, possibly a prelude to another rout of the magnitude last witnessed in 2003. That was the year U.S. equity markets were "on fire" — well at least from the perspective of the U.S. financial press. But from the vantage point up here, on the other side of the exchange rate, investors saw more smoke than fire.

Local market returns at 27% (S&P 500 index) were whittled down to 4% in Canadian dollars.

The Canadian dollar has traded lower, too, in sympathy with the U.S. dollar in recent months, suggesting that short-term factors are undoubtedly at play with recent U.S.-dollar weakness.

A slowing U.S. economy and falling interest rates are undermining the U.S. dollar after two years of strength for just the opposite reason.

But as Grant writes: "Plenty can go wrong with a gold investment, but no harm is likely to come of it if, for example, the Chinese central bank decides it owns enough dollar bills. ..."

The real problem, as Grant only alludes to, is that the U.S. dollar is likely in a long-term bear market.

The long-term problems ailing the U.S. dollar are not shared by the Canadian dollar, however. Thus, further divergence is to be expected in coming years. The United States is the world’s biggest reserve currency, being widely held by central banks the world over, but its share of reserves has been falling from 70% in 2001 to 59% of deposits at end-March, 2006, according to the Bank for International Settlements.

Foreigners will not accumulate credits against the U.S. economy without limit. There are already signs that OPEC countries have been reducing their U.S. dollar exposure in favour of yen and euro reserve assets. The growing deficit in oil is only one of the reasons the U.S. dollar will fall over the long run.

So to bring the problem back to domestic soil, Canadian investors will likely need to hedge U.S. dollar investments against a weak currency. This may not be a near-term problem, given that the U.S. economy appears stronger than some thought, but it is a long-term issue. And to that point, gold stocks are an excellent hedge against the U.S. dollar.

Gold is in much shorter supply than U.S. dollars — it doesn’t come out of a printing press. So it stands that investors are better off holding gold than dollars and in inverse proportion to the latter’s availability.

Incidentally, veteran resource manager Norm Lamarche of Front Street Capital thinks the fundamentals — demand and supply — are very positive for gold.

The price of gold is up in U.S. dollar terms, up by a lot since 2002 when all these problems started for the U.S. currency. It roughly doubled over this time. The Canadian dollar price of gold is up far less, however, suggesting that gold’s rise is in large part a U.S. dollar phenomenon.

That has not stopped investors from pushing up Canadian gold stocks even back in 2003 when the Canadian dollar price of gold was actually down, by 3.3%, over that period.

Lamarche confirms that gold shares do not always trade on fundamentals and profitability. It’s a sector he likens to the "Wild West."

Gold stocks appear to be trading on U.S. dollar weakness more than any other factor since the market bottom in early 2002.

Thus Canadian gold stocks appear to be a strong hedge against weakness in the U.S. dollar. This may not be a wholly intuitive result, but perhaps it is justified over the long run. At any rate, investors would be wise to hold some domestic gold stocks in proportion to the amount of money they have invested in the United States.