Gold: It's All About the Dollar and (Yes Dr. Roubini), Inflation

Gold prices surged to a new high Tuesday on news that India's central bank bought $6.7 billion worth of gold from the International Monetary Fund (IMF). December gold jumped as high as $1,087, before settling at $1,084.90 an ounce on the NYMEX breaking the previous record of $1,072 an ounce on Oct. 14. Prices are now up 22.7% for the year heading for a ninth straight annual increase. (Fig. 1, click to enlarge)

Unusual Correlation

Historically, gold moves in an opposite direction to stocks because of bullion’s traditional role as a safe haven in times of crises. But gold has recently climbed in tandem with rising equities. For example, the Dow Jones Industrial Average, a bet on the economic recovery, is up about 15% this year. (Fig. 2, click to enlarge)

This unusual correlation is driven mostly by excess liquidity, return of risk appetite, and a weakening U.S. dollar. The creation of the U.S. national marketable debt to a record $7.01 trillion to revive growth, along with the Federal Reserve’s maintaining the benchmark interest rate near zero since December 2008, and the prospect of heavy government borrowing to fund deficits, threatens to weaken the dollar and fuel inflation and increased economic volatility later.

Economic uncertainty, inflation worries and the weakening U.S. dollar helped push gold to a new high this year. Weakness in the dollar benefits gold, which is often used as an alternative asset hedge to a depreciating dollar. The Dollar index (DXY) has declined about 10% this year. (Fig. 2) Right now, the general trend is still for further dollar weakness on the back of the Fed’s easy monetary approach, which will be supportive for the whole commodities complex.

Gurus Now the New Gold Bugs

During the bull market just a few years ago, gold was the last place people would look to put their money in for an asset class. Nowadays, almost everyone from investment gurus to store clerks is either piling into or at least talking about gold.

Fund manager John Paulson increased his bets on gold this year, while David Einhorn of Greenlight Capital was buying gold for the first time. Andrew Hall, the star trader of Philbro, has also reportedly been buying gold this year.

Meanwhile, Paul Tudor Jones, also told clients on Oct. 15 that the time to hold gold is now "as faster inflation and increased purchases through exchange-traded funds, and by central banks boost demand amid stagnant mine output."

Roubini: Gold Has Nowhere to Go

In contrast to the renewed enthusiasm in gold, Dr. Nouriel Roubini, in a recent interview with IndexUniverse, says gold will go up only for two reasons: inflation or another Armageddon depression.

He indicates that there is currently no inflation risk, as we are still in massive deflation due to a glut of capacity, weak demand, and high unemployment. He went on to say that we’ve also avoided the “tail risk of another depression.” So, without inflation and depression, gold likely has nowhere to go in the next three to four years.

Dr. Roubini did conclude that there is “a wall of liquidity" chasing assets, and a correction could be coming in risky assets with an anemic recovery.

No Inflation & Avoided Depression?

The warning of a deflationary threat from many mainstream economists such as Dr. Roubini suggests a group-think mentality that the output gap and anemic economic growth would keep inflation low (in the next three to four years, according to Dr. Roubini), in spite of central bank policies creating massive monetary inflation this year.

But Dr. Roubini’s assertion that we face no inflation risk, AND at the same time avoided another depression in the next three to four years seems to defy logic. The “no inflation risk” assumption is a recessionary scenario, if prolonged, would lead to depression, i.e. the W-shaped double dip.

On the other hand, if we have averted another Armageddon depression, this implies resumption of growth. Economic strength typically leads to inflation with everybody chasing assets. Ergo, there is got to be one or the other, i.e., we should either have inflation; dip into recession/depression or…both, most likely before the end of year 2011.

Money Supply & Velocity Spells Inflation

It is well established that there is a positive correlation between the money supply and inflation. The amount of dollars in the system has increased dramatically. (Fig. 3, click to enlarge) But the inflationary pressure from the “wall of liquidity” has been offset by a decline in the velocity due to reduced economic activity and tight credit conditions. (Fig. 4, click to enlarge)

This reduced velocity in money is part of the reason why when stripping out the two stimulus plans, cash-for-clunkers and the home buyer tax credit, the U.S. economy grew a mere1.64% in the 3rd quarter, with quite a subdued U.S. consumer and underlying producerprice inflation data.

However, based on the latest Federal Reserve data, the decline in velocity seems to be ending. (Fig. 4, click to enlarge) If the reversal trend takes hold with an improving GDP outlook, we are likely to see renewed growth in the price inflation level.

Gold Should Be at $2,300?

The fast ascent to new record highs this year has some gold proponents worried it might be getting ahead of itself. But on an inflation-adjusted basis, the prices of almost all commodities have reached their 1980's level, except for gold and sliver. On that note, gold would have to double to $2,291.55 to reach its 1980`s high, which its supporters believe means gold could go much higher.

Confidence Lost at Central Banks

In addition, many U.S. creditors have fundamentally lost confidence in the US dollar and are incrementally diversifying into hard assets and non-dollar currencies. There are indications that China, for example, could be shifting to a partial gold standard through reserve accumulation.

The Reserve Bank of India (RBI) yesterday said it had bought $6.7 billion worth of gold from the International Monetary Fund (IMF). The purchase RBI made is nearly half the 403.3 tonnes of gold that the IMF decided to sell in September to raise resources for lending to low-income countries. Most speculate that China would be the buyer for the remainder of the gold for sale by the IMF.

The deal represented one-eighth of the IMF’s total gold stock. This is the first time since 2000 that the IMF has sold gold to a central bank. India's affirmation of current gold prices is a big sign that the nation sees the recent surge in gold as something that isn't likely to abate any time soon. It also signals that the fall in the US dollar seems to be pushing central banks to strengthen their portfolio with gold.

The purchase will lift the share of gold in India's 285.5-billion foreign exchange reserves from near 4% to about 6%, which is much less than most of the developed world and four times China’s. This lower gold to reserve ratio also suggests that China and India could continue to be the buyers in the gold market.

More than Just Skin Deep

There are others who are concerned that the relatively high prices of gold could crimp jewelry demand from India and China, which accounts for two-thirds of the total gold demand. But, culturally speaking, most Asian countries see gold as the ultimate instrument for value preservation. This tends to keep the demand level of gold fairly stable regardless of the price of gold.

Even if the jewelry demand drops due to the high flying gold price, the current trend is that investment demand for gold could exceed that of the jewelry demand, similar to the trend of the 1970’s. This change primarily stems from the investment community losing confidence in current monetary policies and corporate earnings.

Dollar & Inflation to Support Gold

Of course, people no doubt will keep arguing about whether gold is a legitimate currency. Either way, gold has done well in periods of economic and financial difficulty, such as the 1970s, when the dollar was weak, inflation was high, and confidence in government was low. The weak dollar and inflation perspectives discussed here are enough to support a continuing gold rally for the next few years in the asset class.

Portfolio Strategy

Investors should consider using gold as a way to insure their portfolio by allocating no more than 10% of their holdings to bullion and gold stocks. However, beware that the battered greenback could weigh on operating costs of producers with significant operations outside of the U.S. Companies like Barrick Gold (ABX), Kinross Gold (KGC), Jaguar Mining (JAG), Newmont Mining (NEM) and Yamana Gold (AUY) have substantial operations in Canada, Australia and Brazil, making them vulnerable to a depreciating U.S. Dollar.

Author's Disclosure: No Positions

Comments

[Mad Hedge F...:]

nju News broke this morning that, out of the blue, the Reserve Bank of India bought 200 metric tonnes of gold from the IMF for a handy $6.8 billion. The news set the gold market on fire, boosting the December futures $40 to an all time high of $1,088. It is the largest transaction in the barbaric relic since the Alaric’s Visigoths sacked Rome in 410 AD. It has been public knowledge for some time that the IMF was looking to unload 403 tonnes of the yellow metal in order to fund lending to poor countries. Many traders say this threatening overhang is why gold failed to definitively break out to the upside this year, despite six attempts. The expectation was that China would take this hoard as part of a broader diversification away from the dollar. Bringing India into the fray, which had no prior history of stockpiling gold, is a whole new plate of basmati rice. Not only does this raise the prospect of a bidding war with China for more gold reserves, other cash rich emerging market central banks are likely to join the mosh pit as well, no doubt panicked by the ominously rising whirr of printing presses in the developed countries. My short term goal for gold was $1,200, but I now have to raise that to the $1,300 favored by some chartists in view of the new dynamics. If you want to see my long term target, take a look at the chart below, which has gold zeroing in on its inflation adjusted all time high of $2,358. For those who prefer holding the barbaric relic of the physical kind, visit the tightest spreads in town on American Eagles and bullion at www.millenniummetals.net/ . And while you’re there, sign up for their free research product on precious metals.

Nov 04 06:05 AM

[DONE_SONZ:]

--Nouriel Roubini, in a recent interview with IndexUniverse, says gold will go up only for two reasons: inflation or another Armageddon depression--.The 2 likely scenarios

Nov 04 07:06 AM

[Old Trader:]

Equally possible is a third outcome.....stagflation, or what's been called a "muddle through" ecocnomy. Even the article, with the mention of 3Q GDP growth of 1.64%, after stimulus effects are stripped out, suggests this could well be the case.

Nov 04 09:28 AM

[Solon:]

Was it the 8th Army that had the motto " when not sure or in doubt, run in circles, scream and shout"?
If they run the dollar down to near zero, the debt drops and then 'muddle through' becomes possible,

Nov 04 11:30 AM

[Roger Knights:]

I think the saying went, "When in danger or in doubt, ..."

Nov 04 12:50 PM

[mbkelly75:]

Dr. Roubini spends a lot of time being wrong. CEF is invested in both Gold and Silver bullion and has been trending up for a long time - steadily making higher highs and higher lows. I have 16% of my portfolio in CEF since January and have done well with it. I expect to continue to do so for quite a while yet.

Nov 04 02:23 PM

[GAdams:]

Very good write up. Very correct in my opinion also.

Nov 04 05:12 PM

[talld:]

I believe that what is different to cause the dollar to trade with the market is that the entire market has changed. It is no longer the market it once was and many strategies which were once effective may not be profitable anymore.

The underlying substrate, the foundation of what the market exists in, is in a state of substantial flux, including the dollar.

Buy and hold no longer works as the market itself draws a stock farther than subtle changes in value, technical works differently than it ever did before because the market has substantially changed, because the underlying substrate that it exists within has changed.

The US is fighting two wars, a trillion dollars each when they are done, and the money is no big deal. That cost is two trillion dollars over time, which is one sixth the gross output of our entire country for one year.

Add to this the 9.7 trillion given to the fat cats after they lost their ass and cried to the politicians (and no doubt spent a few bucks on campaign contributions) and add the 1 trillion lost each year in consumer spending on what was once the middle class piggy bank, the home equity loan. Over five years this is 5 trillion in missing consumer spending.

Home equity loans financied 25% of all auto purchases in the US (a couple years ago) and now when that has collapsed, auto sales are down proportionately, and today an auto representative was in the news, wondering when it will recover to previous levels.

Freddie and Fannie had almost no bad holdings because the majority of the bubble happened outside of their loan limit, and now they are suddenly straddled with so much bad paper they are on life support with an IV of taxpayer money turned up to high. Chalk up another trillion at least, probably 1.5 trillion.

There is still almost 1.4 more trillion to mention, and this would be the real US budget deficit each year, which over the next five years will be an additional 7 trillion. So, we are a rich country and we can put ourselves in debt in this way, but we will have to pay it back.

The fact that we are horribly in debt is going to eventually dawn on us, only when we are no longer able to continue racking it up still higher. When we finally reach that limit, whatever it is, and our governments cannot raise any more money through borrowing, then they will go to raising taxes.

The problem is, there are places to go for millions, and billions, and maybe even a place to go for a trillion or two, but there is no place to go for this many trillions. Eventually, as debt mounts someone is not going to get paid. And when that starts happening, it will create a spiraling reaction. Something probably a bit short of panic.

It is already happening in California, and the california government is attempting to hide more of the deficit than they admit to. One of the things the CA government did in the past was to guarantee the stock market investments of the state workers at a hefty 7.5%. Right now, there is more than fifty billion for one year financed through bonds to pay that. They talk about the other deficit, but this one is not mentioned much, but is just as real, and as likely to spread.

This year CA can sell bonds to pay the 7.5% it promised on lost market investments, but if the market falls yet again, how much more might be lost? Who will they borrow it from?

CA residents recently received a notice that the state of california was going to increase withholdings on their income, but would refund it come tax time. A clever way to get a loan, but also an omen of times to come.

And finally, the inherited deficit is another 12 trillion.

What do you think they will do, sit on their hands, or start printing money? If they sit on their hands they will have to reel in the military, stop dictating to other countries, leave the middle east to the middle east, etc. If they print money, it will at least be a while before they will have to give up their empire building ways, so I bet they print it when they need it.

And therefore, gold may well go to any level you care to name, depending on how poorly our elected officials react when faced with no money left on account, none in the bank, none anywhere. Will our military suddenly stop its agenda, or will we print money? Will politicians suddenly turn honest and frugal, or will they print money to pay this off, and pretend it does not exist for as absolutely long as they can?

Nov 05 12:10 AM