The Changing Importance of Gold

When we first wrote an article on gold in the 4^th quarter of 2008, the yellow metal was trading around $740. We outlined at that time the reasons why gold had performed so poorly despite the challenging economic environment. We argued that the reason for the underperformance was largely due to selling pressure from investors who were looking to sell assets in order to generate much-needed liquidity. We recommended buying gold at that time, and our decision was right; gold prices rose to $930 until early February.

We received so much feedback on our article and questions regarding the outlook for gold from our clients that we decided to write an update in early February. At that time we noted that we expected gold to break through the $1,000 level later this year but expected it to remain in a relatively tight trading range of between $820 and $930. After briefly touching the $1,000 mark, shortly after writing this update in February, gold began to move lower and has since then consolidated in a price range between $860 and $940

Dealing with temporarily higher inflation is not such a bad problem, certainly better than having to fight deflation or even worse, chronic deflation. We believe that while investors bought gold in the recent past for safety reasons, that gold will be seen more as an inflation hedge going forward from here. For the future development of gold we expect the following:

• Trading within narrow range ($860 – 950) for the remainder of Q2
• Move towards and eventually breach of the $1,000 mark in Q3/Q4
• Increased demand as an inflation hedge in the coming 12 to 18 months
• Increased demand from the jewelry industry and central banks
• Increasing supply/demand shortfall supporting higher price levels
• Gold price to move towards $1,400 in the next 12 to 18 months

We expect this upwards movement of gold to take place in an economic environment of increased economic growth, rising interest rates and inflation, further recovery of equity prices and an overall normalization of the global financial system. This de-pressuring of the global economical/financial system should yield increased money flows to emerging markets and “commodity currencies” such as Australian Dollar and Norwegian Crowns.

We expect to see significant outflows from the U.S. Dollar and an increasing trend towards global diversification of global currency reserves. This is caused by most central banks looking to reduce their U.S. Dollar specific risks, a trend that might go on for several years to come. This move would give further evidence that the U.S. Dollar is losing its status as the singular global reserve currency. In our opinion, the share of global currency reserves held in U.S. Dollar could fall by almost 20% in the next 3 years.

This structural rebalancing will support the devaluation of the U.S. Dollar, which has started already, and could result in a corresponding devaluation of 20% or more against other major currencies.

Comments

[PastTense:]

"Gold price to move towards $1,400 in the next 12 to 18 months"

While I expect gold to eventually go up very substantially (because of the policy of the Fed and Obama), I don't see any reason for it to go up that much that soon--the economy isn't recovering at all yet.

May 19 08:15 PM

[Dean M:]

I agree with the part about a structural rebalancing away from the dollar that's already started which will spur some inflation and hold gold up at it's elevated levels for some time to come.. But I am not in the green shoots camp and I don't see growth coming back to the global economy any time soon. I definitely can't see increased jewelry demand, I don't know where you got that from.

May 19 08:24 PM

[Market Sniper:]

You lost me with the "economic growth." While we all wish and hope for such growth, I fail to see from where it will come. I do not see any growth engine(s) anywhere and I do look. Gold is a very thinly traded market and easily manipulated. As the so-called "price" of gold is one barometer of monetary policy that the common man can see, it is vitally important for perception manipulation that the "price" be kept relatively low. Like a large beach ball being forcefully held underwater. As the cost of the necessities of life continue to increase inexorably in price, at some point, that perception "control" will be lost in the inevitable tsunami tidal wave of fiat, both digital and paper, wash over this country. It can not be otherwise due to current insane monetary and fiscal policies. The iron hand of history speaks loudly on the issue. Ignore it at your own peril.

May 19 08:52 PM

[Mad Hedge F...:]

Pter Monk still likes it. Barrick Gold (ABX) snared approval for its Pascua-Lama adventure after Chile and Argentina signed a tax treaty on how to treat the mine’s profits. When completed, the $3 billion, 13,000 foot high project will be one of the world’s great engineering achievements, extracting a forecast 800,000 ounces of gold and 35 million ounces of silver in the first five years. This will raise the company’s production by 10% at a time when precious metals are getting increasingly hard to find. Just another reason to buy one of the world’s best managed companies producing the most sought after product.

May 19 11:12 PM

[Missing_Link:]

That's precisely why I think it *is* possible (not necessarily likely, but possible).

Gold does well both as a hedge against inflation and as a safe haven in a panic. I think the inflation part is essentially certain in the long run (probably not in earnest until fall '09 at the earliest). The panic part is not certain, but is entirely possible if the slump lasts longer than the public believes it will (almost certain) and the current market rally fails (which I believe is more likely than not).


On May 19 08:15 PM PastTense wrote:

> "Gold price to move towards $1,400 in the next 12 to 18 months"<br/>
>
> While I expect gold to eventually go up very substantially (because
> of the policy of the Fed and Obama), I don't see any reason for it
> to go up that much that soon--the economy isn't recovering at all
> yet.

May 19 11:45 PM

[Donald Ingram:]

Good post, however I think your premis of economic recovery going along with a higher gold price is some what off the mark. I do think that the dollar will lose it's preeminence as the worlds reserve currency choice and this will be part of the flight to gold along with the deepening and ongoing economic crises. Also I see gold at $1,650 sometime in early 2011.

May 20 03:15 AM

[user41653:]

Where are Those Good Green jobs , ??? my Nephew graduated a year ago from college ,finaly got a job . He works for a out fit that installs solar panels , there s about a dozen people working there , they work part time usually not enough work most weeks to work full time , they get $9 a hour when they work , No benifits thats it .
Now I guess thats a Ok job for a 23 year old living at home , with no rent or food bills to pay all he pays is his gas and car insurance. But theres NO Future in that job at least no financial future and its not like hes learning a trade he said after a week on the job he as good at it as any of the older guys . Is this what Obama is talking about ?? When he talks about green jobs , ?One of his task force was on TV this morning talking about jobs for people insulating homes , they consider those "green jobs " I wouldnt guess theres much of a future in a job like that either . So were exactly Where are ALL these MILLIONS of GOOD GREEN JOBS going to come from ??? Will they Pay $50K Year , thats just a living wage these days , Well they Have Benifits , Retirement programs I guess We know the answer dont we.
Turns out All Those Good Green Jobs well there Kinda like Hope and Change sound great but really don't happen much in the REAL WORLD

May 20 12:35 PM

[Jeff Nielson:]

Agreed, Market Sniper. There will be NO U.S. "economic recovery" - period! The only possible outcomes for the U.S. (due to its totally unsustainable mountain of debt) is default and bankruptcy, OR hyperinflation - THEN default and bankruptcy.

In either of those scenarios, gold's future (i.e. $3000 - $5000/oz) is assured, especially since most of the rest of the world will be enduring an era of high inflation - thanks to reckless monetary policies and the tidal wave of money-creation (out of "thin air").


On May 19 08:52 PM Market Sniper wrote:

> You lost me with the "economic growth." While we all wish and hope
> for such growth, I fail to see from where it will come. I do not
> see any growth engine(s) anywhere and I do look. Gold is a very thinly
> traded market and easily manipulated. As the so-called "price" of
> gold is one barometer of monetary policy that the common man can
> see, it is vitally important for perception manipulation that the
> "price" be kept relatively low. Like a large beach ball being forcefully
> held underwater. As the cost of the necessities of life continue
> to increase inexorably in price, at some point, that perception "control"
> will be lost in the inevitable tsunami tidal wave of fiat, both digital
> and paper, wash over this country. It can not be otherwise due to
> current insane monetary and fiscal policies. The iron hand of history
> speaks loudly on the issue. Ignore it at your own peril.

May 20 01:09 PM

[2contango:]

Seems overly optimistic. In a deflationary environment, which seems likely, gold won't fare well.

And if we get solid economic growth, the fear factor that's fueling much of gold purchases now will fade, leading to flat prices at best.

May 20 01:56 PM

[Screwloose:]

Gold's been acting very strangely for the last month. It's been grinding steadily north from $868 on April 18th - with very little obvious resistance from the usual suspects - despite the VIX falling; the DJIA [still] rising and not a sign of inflation on the horizon.... yet.

Seventy dollars up, on low volume, for no apparent reason. The last time it made a, short-lived, jump of that size was on March 18th when Energiser Benny announced that he was going into the counterfeiting business.

As it has fallen to it's lowest value this year in many other currencies; this stealthy rise must be, in part, a reaction to the dollar losing value - 3 more days like today and we're through $1K/oz by default - but there's something else going on that's evidenced in the sheer nervousness of the COMEX trading.

Peter Cooper nailed this sudden trend-change - if not it's exact size - to the day, completely against the flow after a truly dire week; so maybe this new strength has a Gulf component, as that's his home area. Was the opening of the new Dubai exchange/vault the catalyst? Will the rumored repatriation of the GCC countries' gold stocks expose something nasty... Or is a big bank buying to cover-up a hole in it's alleged holdings?

May 20 04:48 PM

[formosan_be...:]

Of the two banks and three brokers where I deal, none of them support Norwegian Krone transactions; what options are available as to how do you get purely long NOK?

The only compelling and easy solution I know of is a proxy-play of energy and NOK, that of Statoil, ticker STO US.

May 21 01:08 AM

[formosan_be...:]

The author probably means nominal growth when he says "growth", which is to say real growth plus inflation, especially since internationally, statistics are mostly US$-denominated. I agree that if we measure growth in ounces or tones of gold there will be no growth, but they’ll kick-start the economy nominally in US-dollar terms, rest assured.

Those calling for Japan-type economic malaise and deflation are looking at history incorrectly. I agree Quantitative Easing did not work in Japan and many other examples, but the deflationists don’t seem to understand that there is no historic precedent for what is going on today. The country whose currency is the international currency of reserve has massive expansionary policies, including QE and is leading its allies an enemies alike to implement similar policies.

Moreover, Quantitative Easing, ultra-loose monetary policy and expansive fiscal policy is not unique to Energizer-Benny (great moniker whomever came up with it) and the Obama administration, they are merely the conductors of the choir of reflationists. UK, Japan and Europe are all practicing these expansive policies to similar, albeit to lesser degrees. Even countries that haven't been washed away by the financial tsunami are practicing similar policies (read Canada and Australia) probably due to moral suasion from Uncle Sam, in a similar vein to the gov’t having pushed good banks to take TARP funds even if those banks didn't want / need them.

Keep in mind that the greenback has only been king fiat since 1971 when Nixon took the US off the gold standard. In the early part of the 20th century the US established itself as the most important economy in the world, overtaking Great Britain. During most of the 20th century greenbacks were backed by gold, though they did debase it a couple times by altering the exchange ratio of greenbacks per ounce. When the UK was economically dominant, the Pound Sterling was backed by gold. Basically for the past 4,700 years, when the Egyptian Pharoahs first minted gold coins in 2,700 BC, and subsequently when King Croesus, ruler of Lydia (560–546 BC), began issuing gold coins, with a standardised purity for general circulation, gold has been the internationally accepted currency of reserve and trade. There have been plenty of countries that experimented with fiat currency (think Weimar Germany, or Chiang Kae-shek’s Chinese Yuan) but those countries never had the king currency and ran into hyper-inflation as they printed more. I digress…

The irresponsible continuation of Bush-Cheney-Greenspan expansionary policies under Obama-Geithner in the US and their counterparts, particularly in the UK, is nothing short of amazing, yet predictable. I've been investing over twenty years and I do not remember a time when the macro-trend and most risk-adjusted-rewarding investment strategy seems so obvious and it doesn’t spell deflation. After the massive write-offs of CDOs, MBAs, bad-loans, bankruptcies, etc, that are currently keeping inflation benign, the greater factor will become the flood of freshly printed dollars, Euros and GB Pounds and the ten times multiplier effect that each new note has once in circulation.

There are a few other points to keep in mind…

First, it doesn’t matter that the fear factor is subsiding as seen by VIX and inflation is almost non-existent as measured by CPI recently; gold and other real assets are going up because of the rapid dilution of value one will get by holding fiat currencies. Most recently M3 was actually sequentially flat month-on-month the last month of record (March 09), but once the write-offs are done, real growth will be anaemic and the governments will keep priming the pumps as they will desperately settle for nominal growth because of its “feel-good factor” (Hey my wages are up a noticeable 5%. Hey my cost-of-living gradually crept up 10%). I anticipate that two to five years down the road, we will go into a post-crisis-crisis, and real-asset inflation will be on the rise even if it is not reflected in the statistics (i.e., I am in the camp that inflation and unemployment are grossly understated and GDP is overstated) and major paper currencies will get pummeled together. Depreciating currency means import inflation and it may mean rising interest rates to support the currency and to counter inflation (though the latter only works once the economy stalls again).

Second, markets and investors are forward looking and the rising real asset prices are reflecting what it sees coming, not what is today (read a high misery index, i.e., inflation plus unemployment).

Third, let's not forget that from late 1980 to late 2001 (the CRY Index went from 337.6 to 96.4), excepting a few cyclical run-ups on the way, we were in a secular commodities bear market, which resulted in massive under-investment in exploring for and getting the good stuff out of the ground, whether that be energy, metals, food or precious metals. The bull market that followed from 2001 to 2008 (Cry from 96.4 to 474) but began in earnest in Aug 2007 to peak in July 2008 was too short-lived and to sharp to seriously reverse this under-investment phenomena. (I grant that CRY is not the best index as it is so overweight oil, but it is the most widely used to make a general commodities argument).

Moreover, the last time oil was last near US$150 per barrel it was a both a demand and supply-side shock, whereas previous oil crises were supply-side shocks only. The demographics of the BRICS (Brazil, Russia, India, China), not to mention over-populated Indonesia and Africa have not changed. Moreover, these rapidly growing populations are climbing the food chain and will be consuming more cars, more fuel, more meat (which means more grain). The financial tsunami has given us a temporary respite from inflation, but that’s it, temporary – long real assets! (exclude property where there is supply overhang from their previous property bubbles, note US and Spain).

I recognize that what I’ve written is nothing new, but a compilation of many common views. I write this (perhaps verbosely) because I wanted to lay out all the arguments I hold in one piece to see if any of what I believe to be misguided deflationists to present a good counter-argument.

May 21 01:58 AM