Interpreting $500 gold
December 4, 2005
The interesting thing about gold crossing $500/oz. is that anybody cares at all. Molybdenum, a much more important metal from an industrial standpoint, soared from $2.50 to $35 and never popped up on CNBC. Nickel prices have gone up much more than gold. So what’s the fascination with the useless yellow metal?
It’s simple: $600/oz. gold has the potential to blow up the US and worldwide economy, while $35 molybdenum does not.
Gold bullion, of course, does not send out powerful waves of economic destruction. It doesn’t do much except sit in vaults, decade after decade. Gold is, simply, what it has always been: money. It is money not because people use it in transactions (they do not), but because it serves as a benchmark of monetary value. Gold’s monetary value doesn’t change much. While it would be a bit rash to insist that it doesn’t change in value at all, as there is no definitive way to confirm this with precision, it can nevertheless be asserted that it changes in value so little that it is near-impossible to detect the effects of any change in value; thus, for practical purposes, we can treat it as if it does not change in value.
Thus, if it takes more dollars to buy an ounce of gold, but gold’s value isn’t changing, then one must conclude that the dollar’s value is falling, even though the USD is rising against the EUR and JPY. In this case, it appears that the EUR and JPY are also sinking, a bit faster than the USD. Given a) a 2.25% policy rate at the ECB and something like a 0% rate at the BOJ, and; b) somewhat weak economies in both areas, and; c) no particular desire at either the ECB or BOJ for a higher domestic currency vs. the USD, this outcome is not too surprising.
If it takes more dollars to buy an ounce of gold, one should not be surprised if, over time, it takes more dollars to buy a wide range of things. This process is known as inflation.
The reverse process can also occur: if it takes fewer yen to buy an ounce of gold, there will be a tendency for it to take fewer yen to buy all manner of things, the process known as deflation.
It has been noted, by the Gold Anti-Trust Action Committee (www.gata.org), not to mention Sprott Assett Management (www.sprott.com), gold analyst Peter Grandich and others, that it appears that central banks have effectively sold large amounts of gold via leases in what could be a purposeful attempt to suppress the “price of gold.” There have been a large number of very suspicious futures markets selloffs in the US immediately after the close of the London bullion market. However, I doubt that such actions could account for more than about a $30 (6%) depression of the gold price, as such price depression makes gold all the better purchasing bargain–and thus we see increases in bullion demand as well.
From this it follows that what we are really watching in the “gold” market is the dollar, or whatever currency one wishes to measure against the “monetary value measuring rod” of gold. Thus, the primary influence on the “gold market” is not mining supply or jewelry demand, but the sort of things that interest forex traders, such as central bank policy.
Except for this $30-either-way sort of thing, gold cannot be dramatically “overvalued” or “undervalued.” There is a lot of talk about “inflation-adjusted gold prices” or “gold/oil ratios” (significant for oil but not for gold) these days. This sort of thing is best ignored, in my opinion.
Also, it is not at all the case that gold is a “haven in financial turmoil.” It can be, but that does not increase its value. Note that gold did not rise in value significantly in 1914-1916 (First World War),1929-1932 (Great Depression), 1939-1942 (World War II), or 1998 (Asian Crisis, Russian default and LTCM).
The $500/oz. mark was matched only two other times in the last 23 years, in 1982 and 1987. This has served as the “floor” of dollar value ever since the end of the 1970s inflation. If we break through this “floor” by going to $525/oz. or so–as I think is likely–that would be a technical development of enormous significance. It’s significance would come, in part, from the fact that many people think it is significant: if there is no evidence, at this point, of some development that could credibly turn around the long decline in the USD/gold bull market, that would constitute a strong signal to dump dollars and acquire gold.
Thus, what I am personally looking for here, is anxiety and action from the market and various monetary authorities. Anxiety and action creates an environment that feels like a crisis, but the effect of this can be that real crisis is averted, since everyone is making an effort to avoid it. Conversely, if nobody recognizes the significance of the situation, then no action is taken, and the crisis plays out further. Can you guess which scenario we are in now? The stock market is rallying, it is said, because of expectations that the Fed is about done, and the fact that the 3Q GDP core personal consumption expenditures deflator came in at a 1.2% annual rate, quite subdued and actually lower than recent readings. Hey, it’s Goldilocks time! (The “Goldilocks” Economy was a term from the first half of the 1990s, indicating that the economy was neither “too hot”–inflationary–nor “too cold.”)
Ah yes: the Fed. There has been a lot of talk about the “neutral” rate for the Fed. No such thing exists, as the relationship between the Fed’s interest rate target and monetary conditions is, as noted over the last two weeks, chaotic. One cannot say that a 4.5% policy target is “accommodating,” and a 5% target is “just right” and a 5.5% target is “restrictive,” because all we really know about the effects of such policies is: they would be chaotic. Sometimes a 0% rate seems to be “insufficiently accommodating” (Japan in the 1990s) and at other times a 60% rate leads to nothing but more and more inflation (Turkey in the 1990s).
That said, we can nevertheless make a few suggestive observations. There have been four previous bull markets in gold (i.e. episodes of a declining dollar) between the end of the gold standard in 1971 and the present. Each one ended with the Fed in double digits. At present, the 4.0% policy rate is roughly equivalent to the official rate of inflation, a situation that, in 1993, was considered wildly accommodative. However, nobody really wants a Fed target of higher than 4.5% or so. The five major recessions of the last 40 years–1970, 1974, 1982, 1991 and 2002–tend to get blamed on the Fed, which raised its target rates significantly before each event. To this must be added the fact that the recent period of super-low short rates has encouraged all manner of aggressive financial leverage, both among consumers (especially in housing) and professional financial types, although corporations have been relatively restrained. Besides being overloaded with debt and leverage, none of these parties are prepared for rates above 4.5% or so. Nor do politicians particularly want higher rates. Finally, if you were at the Fed, would you want to be blamed for the next recession?
Now, it is not at all necessary to raise the Fed’s target rates to fix the sagging dollar problem. The proper solution is to sell assets from the Fed’s balance sheet, thus reducing base money supply. This would support the currency and lead to lower interest rates (in today’s case, it would allow present low rates to continue). There is some evidence that the Fed has been leaning in this direction a bit, as base money growth rates are rather low. However, to pursue this strategy properly would mean that the Fed would have to give up the rate-targeting system, and adopt a system of direct monetary-base adjustment. This would be a big move, especially as it would not be at all clear what would come next. Also, the last experiment in “monetarism” in late 1979-1983 or so was not regarded as a big success (obviously, since it was abandoned), although the brute purpose of stopping the 1970s inflation was accomplished.
I have a twinge of hesitancy about explaining all this, as I am positioned to profit from a further dollar decline, i.e. a further “rise in gold,” i.e. the general incompetence of the world’s central bankers. Nevertheless, it is important for the greater good to explain these things. Most likely nothing would be done anyway, although maybe the central banks of China and Russia would take note. We are primarily laying the groundwork for what may come afterwards, if it turns out once again that the present interest-rate-targeting system is later recognized as a failure.
One thing we may see, within the next six months or so, is a dramatic acceleration of the dollar’s decline, and gold’s bull market. If this happens, whatever remaining effectiveness the Fed may possess will slip away even further. Crisis time! Next week, we’ll take a look at a specific example, the summer of 1972.