Understanding Gold’s Movements
November 5, 2006
I apologize to readers for not keeping up with the website recently. I have had quite a lot to do, and need a break on the weekend rather than another task. Thus, for now let’s expect updates maybe only every other week, or maybe not even that much, until the situation is more appropriate. I am still looking forward to describing the Amazing Summer of 1972 at some point, but that is an undertaking that will take a bit of effort.
I also see that gold has apparently finished its consolidation and is thus ready to continue its long bull market higher, or in other words the dollar is ready to continue its long journey lower, becoming more and more inflationary. It has appeared that The Powers That Be have made quite an effort, especially in this pre-election period, to “keep a lid on gold” or keep the dollar from sagging, but that they are now pretty much out of bullets. This is reflective of TPTB’s thinking apparently because one does not need any bullets, or gold bullion or whatever, to support a currency’s value, merely proper understanding of the techniques of currency management. The website LeMetropoleCafe.com has done an excellent job of following TPTB’s action in the bullion market, and is well worth the $120/year or so for those who are interested in such things.
There are a number of people who regard the dollar/gold market to be an up-to-the-minute reflection of macro fundamentals. This is a sort of extreme “efficient markets” stance. In my experience this is not the case. The general direction (primary trend) tends to be set by the so-called fundamentals, but the manner of movement within that trend tends to follow the ebb-and-flow described by technical analysis. This is true even when subject to manipulation by TPTB. TPTB sold gold heavily in May, and this created a large reaction because the market was technically overextended and due for a correction in any case. I suspect that if things had been left to their natural path, there would have been a selloff to the $600 area. TPTB also sold gold heavily in October, but by then enough time had passed that people were ready to become bullish again, and their selling was met with super-strong buying of physical bullion, leaving the price largely unchanged.
It seems to me that people with long experience in the markets tend to simplify things as much as possible. This makes their opinions seem quite rudimentary compared with those people (generally younger and less experienced) that want to try to integrate every factor imaginable. However, primary trends are generally set by rather simple factors. At this point, I would say that the dollar’s trend of decline is fueled primarily by a lack of action or concern about previous decline. This may seem self-referential, and it is. That is the reality of currencies. All trends come to an end, and I would expect this one to come to an end just as others in the past have ended: with rather aggressive action by the Fed, with target interest rates likely in the neighborhood of 10%+ or a change in operating methodology away from interest rate targeting altogether. Neither is on the near horizon, so I tend to conclude that the primary trend will continue.
Yes, my basic analysis is that simple. But it has taken a lot of effort and (I hope) insight to make it that simple. Some may ask: what about the current account deficit? Base money creation? M3? Iran? Jewelry demand? Diversification of central bank reserves? etc. etc. I don’t see any of these as being definitive in their effect, but mostly consequences of or aspects of the general macro environment. So, if we’ve concluded that the primary trend for gold remains UP and likewise the dollar (versus gold) DOWN, then the only other decision to make is in what manner gold will go up. Obviously, gold doesn’t go up every day or even every week. Like most markets, since 2001 gold has had a series of vigorous uplegs punctuated by consolidations lasting several months at least. Sentiment has become very bullish on the uplegs, and becomes quite bearish (or at least despairing) towards the end of corrections. This is a reflection of typical market action, and the nature of speculators, more than gold “fundamentals.” Adam Hamilton of Zeal has done about as well as anyone in describing this secondary ebb and flow, and his commentary is well worth the $99/year or so for anyone involved in the precious metals markets. (www.zealllc.com)
There has now been a long consolidation of roughly the average length and severity of past corrections, and in the last week or so the market seems to have confirmed that it is ready for another leg higher (as opposed to the bull market having ended). I am looking forward to putting my Inflation Cassandra hat on again! I expect this next leg to be quite stunning. The Elliot Wavers will point to the Third of Third wavecount, though I don’t. A top of $1200/oz. or so is my working hypothesis, followed of course by another long consolidation in which the price may then fall to $900 (25%) and everyone will be in despair that the gold price is so “low”!
Last year, if you had told people that gold would be at $620/oz. (from $440/oz then) and people would be afraid to hold the stuff, they would have laughed. $620/oz. is not a low number. Except for a few weeks earlier this year, it is the highest gold price/lowest dollar value in 25 years. The situation is consequently the most inflationary in 25 years, and poised to become much more inflationary. The next big shocker for Joe Public may be dramatic rises in food prices. This has already begun as wheat, corn, OJ and beef make dramatic new highs. I think all will double again from present levels eventually, in a manner similar to what base metals have done. The big shocker for financial types may be that the Fed is Not Done, and will in fact hike rates to over 7%. This would be quite murderous for asset markets everywhere, not to mention the economy as a whole. The Fed is well aware of this, and will postpone that date as long as possible. They may even cut rates a few times before then. It is this postponing and foot-dragging that will largely drive gold to $1200/oz. in my opinion.
Oddly enough, it is not “money printing” which is causing currency decline at this time. Monetary base expansion has been very low, about 0-2% annualized since the start of 2006. This may seem like a currency-supportive factoid to some (like Larry Kudlow on CNBC), and indeed it is in the sense that the Fed is not “flooding the world with dollars” or some such thing. In the present interest-rate-targeting environment, monetary base creation is in large part the consequence of the interest rate target policy. About 85% of all the dollars (monetary base) in the world are held by foreigners. If I recall correctly, about 60% of the entire monetary base is in the form of $100 bills, which are almost never seen in the US. The low monetary base figures seem to imply that these holders of $100 bills (one can imagine who they are) are starting to use other currencies or other means to do business, and are effectively giving their dollar bills back to the Fed. This seems like a currency-negative development to me.
The Fed is run by committee, which makes it very politically sensitive. The fact of the matter is, the Fed is likely to take action to stop the inflation when it is politically advantageous to do so. At this time, there are vast constituencies that benefit from inflation. Many citizens are deeply in debt, and would benefit by having their debts inflated away. This also applies to those with a mortgage, especially a big one, even if they have no other debts. Many corporations would like to inflate away their pension or medical liabilities, or take advantage of the “stealth wage cut” provided by inflation. They generally benefit from a decline in the forex market value of the dollar as well. Many asset managers get paid on nominal gains, and inflation has tended to increase those gains (until it doesn’t). The government itself has colossal liabilities that could generally be inflated away as the CPI is routinely understated. Also, tax rates are adjusted by the CPI so an understated CPI results essentially in higher taxes. Higher taxes don’t really help the government or anyone else, but almost everyone in government thinks they do, so they are not opposed to this development.
I expect to see a certain undercurrent of anxiety when we get to about $680/oz. for gold, which will come to the surface after we break the May highs and reach $750/oz. or so. Even if the Fed decides that it is politically advantageous to “fight inflation,” I doubt that they really know how to do this. Even the language is misleading: inflation is ultimately caused by the currency managers themselves. It is not some entity existing outside that one “fights.” A Fed that is “fighting inflation” is probably swinging at shadows, when what it should be doing is understanding how to learn from its mistakes and alter its own policy so that it is not inflationary! By the time people end up on the Board of Governors of the Federal Reserve (or worse yet, become Chairman!), they would rather shoot themselves in the head than admit publicly that they don’t understand basic currency management, and that all the monetary problems they see are a result of their own ignorance. These institutions have had over thirty years to learn now, and apparently haven’t.