01/20/2012 01:54 pm ET Updated Mar 21, 2012

The Real Value of the Dollar and Gold

If you ask most investors what is the main driver for the price of gold they are likely you tell you that it's the direction of the U.S. dollar. Therefore, the only due diligence most investors perform is a perfunctory glance at the Dollar Index (DXY). While it is true that the purchasing power of the dollar is a key metric to judge the direction of gold prices, the DXY will only tell you what the dollar is doing against a basket of 6 other flawed fiat currencies.

The main component of the Dollar Index is the Euro Currency, which represents a 58% weighting in the basket of currencies. It logically follows, if the Euro is tanking, the Dollar Index could increase regardless of the fundamental condition of the U.S. dollar. In order to truly access the intrinsic change in the value of the dollar you must first determine; the level and direction of real interest rates, the rate of growth in the money supply and the fiscal health of the government. When analyzing the dollar using those metrics, it is clear that the intrinsic value of the dollar is eroding in an expedited manner.

The Ten year Treasury note is now yielding 1.85%, which is down in yield from 3.34% a year ago today. Meanwhile, the year over year increase in Consumer Price Inflation jumped to 3.4% in November, up from 1.1% in the 12 months prior. Therefore, real interest rates are not only negative but are falling. Falling real interest rates reduces investors' appetites to hold dollars and increases their willingness to buy gold. Negative real interest rates cause consumers, businesses and governments to borrow more money. When more money is borrowed into existence, the supply of money grows. Increasing money supply growth reduces the value of dollars already in existence. The YOY change in M2 money supply growth is near 10%. Since U.S. economic output is around 2%, the supply of goods and services is growing far below the rate of money supply growth. This causes aggregate prices to rise and reduces the value of the dollar, while boosting gold prices.

The level of U.S. Federal debt is serving to destroy confidence in the currency. Our government just requested permission for yet another $1.2 trillion increase in the debt ceiling. U.S. debt stands at over $15.2 trillion and is now estimated to be larger than America's entire economic output in 2012. The proposed increase would boost the debt ceiling to $16.4 trillion and would be sufficient to last only until the end of this year.

U.S. deficits are running over $1 trillion per annum and our accumulated debt amounts to over 700% of Federal revenue. And just last week, we learned that the monthly budget deficit climbed to $85.97 billion in December, up from $78.13 billion in the same month a year earlier. The sad truth is that our debt is already intractable and becoming more so by the day. The only relief from such debt will be a default on the part of the United States. A sovereign U.S. debt default by either the explicit (restructuring) or implicit (inflation) method would be pernicious for the dollar and massively bullish for gold.

The simple truth is the U.S. dollar is under increased assault from negative real interest rates, increased counterfeiting from the Fed and a national debt the government is attempting to inflate away -- that truth isn't made less painful just because a European vacation may be getting cheaper.

Since the intrinsic value of the dollar continues to deteriorate, long-term investors would do well to ignore the dollar's temporary and beneficial measurement against the Euro and focus on its true fundamentals, which are forcing investors towards gold.

Michael Pento is the President of Pento Portfolio Strategies