The New Gold Rush: Lots of Risk

Gold was in the news Tuesday, setting a new all-time high of $1085/oz. as of this writing. The first chart here shows nominal prices, while the second shows gold in constant dollar (real) prices. Either way you look at it, gold has enjoyed a pretty spectacular run since early 2001. At the risk of slighting the obvious geopolitical risks that motivate gold buyers these days, gold has for the most part benefited from years of accommodative monetary policy from almost all of the world's central banks. Easy money helped inflate the housing bubble several years ago by keeping rates artificially low. Easy money works by effectively lowering the hurdle rate for purchasing hard assets. People must always ask themselves this key question before buying gold, commodities, or real estate: "Will gold (or oil, or copper, etc.) prices in the future rise by more than the interest rate on safe assets?" The lower the interest rate, the easier it is to answer in the affirmative.

Easy money thus erodes the demand for money and boosts the demand for hard assets, resulting in rising tangible asset prices. Money loses its value relative to things, and that's what inflation is all about.

Rising gold prices are thus a signal that interest rates are too low and monetary policy too easy. There is more money in the system than the system wants, and that is the fundamental monetarist equation for inflation. That we haven't seen inflation show up in the CPI (well, at least not very much so far) is simply a reflection of the long and variable lags between monetary policy and the real world.

I've always thought that the primary objective of a central bank that chose to adopt interest rate targeting as its method for implementing monetary policy (as all major central banks have done) should be to pick the interest rate that leaves the market indifferent between buying government bonds and tangible assets such as gold and real estate. In practice, this could be described as a type of gold standard: the central bank should simply raise or lower interest rates (by selling or buying government bonds) in order to keep the price of gold within some specified range. Shrinking or expanding the money supply in this fashion would automatically keep the market indifferent between buying financial assets and tangible assets, because it would avoid monetary excesses or deficiencies, and thus deliver an essentially zero rate of inflation. Such a policy would inevitably lead to a very low and stable interest rate environment. And that, according to supply-side tenets, would be the best way for monetary policy to stimulate the economy.

If the Fed were to do this today, what should its target price for gold be? That is a question that has no definitive answer, but I'm going to guess that it should be somewhere in the $400-500/oz. range. As it happens, the real price of gold over the past 100 years has averaged about $450. If $450 is the price of gold that corresponds to "neutral" or zero-inflation monetary policy, then gold today is trading for a premium of over 100%; buying protection against inflation in the gold market is very expensive. Put another way, the Fed is going to have to continue to stand pat, and/or inflation is really going to have to accelerate just to keep gold from falling. If the Fed were to tighten policy sooner than expected, and with vigor, gold prices could tumble dramatically.

I'm not arguing against an investment in gold today, since rising gold prices seem to be the path of least resistance for now, considering that with one single exception (the Australian central bank), the world's major central banks have given every indication that a tightening of monetary policy is unlikely in the near future. My point is that buying gold is a very risky proposition now that it is trading at these lofty levels. In a best-case scenario for gold, we might see it revisiting its 1980 high in today's dollars (about $1800), but in a worst-case scenario it might fall back to $400. That's a very lopsided risk/reward proposition (aka an extremely speculative investment).

What could drive the worst-case scenario? Gold prices are extremely vulnerable to the mere suggestion that the Fed might begin reversing its liquidity injections. Gold prices are also very vulnerable to signs of stronger-than-expected growth, since the market can easily put two and two together and realize that a stronger economy means an earlier and more aggressive monetary tightening.

And while on the subject of vulnerable gold prices, these same arguments hold for T-bond prices. Yields on Treasuries are very low, mainly because the Fed is expected to be very easy for a very long time. Even the slightest change in those expectations could result in a sharp rise in Treasury yields, and a significant decline in T-bond prices.

Comments

[kelvin8:]

You have not mentioned the marginal cost of production, which will always eventualy drive price for any desired commodity.
With cuurent marginal costs around $750-$850 and ounce, any drop below that price would be short lived, as it would shut down mining operations, thus reducing supply until demand would bring the price back up.
All academic of course since gold is no longer functioning as a commodity, is is functioning as a cuurency. Until be have healthy financial and currency markets ( if ever again in the forseeable future) gold will comtinue to be a safe haven.

Nov 04 11:05 AM

[Steve in Gr...:]

Thanks, Mr. Grannis, for the note. For what it's worth, my guess is that for the next 12 months, the Fed is locked into a zero interest rate policy and ongoing quantitative easing, because of the economy's weakness, the Fed's philosophy and political considerations. Beyond that, my crystal ball is cloudy.

Of course, the beard speaks today, so we will see. But I suppose the big up moves in gold yesterday and so far today mean somebody has read a draft of Big Ben's press release.

Nov 04 11:11 AM

[oldgoldbug:]

Excellent article.
Given the weakness of the US economy, I agree a tightening of monetary policy is unlikely so gold will continue to grind higher. Having been there for the race up in the 70's and 80's I can assure you this time, so far, is different. Back then gold jumped up (and fell back) in huge swings. The run to $875 seemed to happen in a matter of days and after it blew off, rallies were stunted affairs. We haven't seen a blow off yet in gold. It just keeps going up.
I would guess Bernanke has had more than one conversation with Paul Volcker about what it takes to control inflation. Volcker did a masterful job of putting the genie back in the bottle, but at a high price. Long Treasuries were yielding 14% which is not a bad return, if inflation is controlled. If inflation is not controlled, then the Weimar Republic is a few steps away.
If your analysis is accurate, perhaps what the gold market is telling us is that the "zero inflation value" is going to move upward.
In any event, gold's status seems to have moved upward from "barbarous relic" to "mainstream hedge". I don't think it is in everyman's 401k yet so it probably has further to go.

Nov 04 11:27 AM

[AtTheMurph:]

Gold may temporarily be effected by a Fed tightening but that tightening will also create a deflation of the $ carry trade bubble and cause huge amounts of money to flow back to the US. All that money is really going to be a repatriation of inflation the US has been successfully exporting and will cause an even greater collapse of the dollar going forward. Short term we will see a big bump in the dollar but that will be exactly the time to get out because the crash will be inevitable and gold will then rocket higher.
I'm not a timer so I don't have the stomach to play that game. I'll be short the dollar and long gold for the foreseeable future because gold is the only reliable store of wealth and the fiat currencies have been exposed finally.

Nov 04 11:45 AM

[Donald Ingram:]

"Benefited from easy money"?
If you ignore a 20 year stretch 1980-2000 of declining returns on gold, when gold was a "bad" word in the financial community at large and was pilloried as just another 'commodity' with no monetary role. Far be it - an easy money policy encourages purchase of not only real estate (your hard asset) but also other assets such as gold.

"Easy money thus erodes the demand for money"?
No. Exactly opposite - easy money begets more of the same with upward demand for even more as can be born out by the amount of credit creation during the dot com and housing bubbles.

"Rising gold prices are thus a signal that interest rates are too low"?
No. The market enjoys these periods of low rates as can be seen by the tremendous growth in the indices along with the price of gold as it was seen by the majority as 'just' another commodity.

Most of your article I disagree with. The current high price of gold has nothing more behind it than a loss of confidence in fiat currencies and a fear of wealth being destroyed by those same currencies. "Very risky"? I don't think so, only risky if you wait to buy at the top as I suspect you might. You don't make money by buying at the top and selling on the bottom. Gold is back to fulfilling it's monetary role.

Nov 04 11:46 AM

[Angel Martin:]

Good article.

Those with significant % of portfolio in gold need to watch for signs of sustainable growth very carefully.

As soon as growth gets going, rates are going up and gold is going to crash.

(also, be very skeptical of those who try to explain away every data point that shows growth. If employment, retail, imports, corp revenues and profits are all showing growth, it's a real recovery, not some big conspiracy of faked data.)

Nov 04 11:58 AM

[Pax Americana:]

Thanks for this highly illuminating Article, which explained to my satisfaction how the GLD price movements, and the Feds interest rate work in reality, of which I was not cognizant before this Article made its appearance. Forewarned is forearmed, some say.

Nov 04 12:13 PM

[mloren:]

Nice article. It is interesting putting gold in perspective from its fall in the early 1980's. An interesting argument I have seen for owning gold is that it is like insurance against the likelihood of policy errors that may occur with managing and reducing the deficit. If the economy does turn around and the deficits are managed, gold will likely crash. But like an insurance policy, we should hope that we may never have to collect on the policy.

Nov 04 12:31 PM

[Mad Hedge F...:]

cde ) 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 01:09 PM

[Screwloose:]

To judge how far gold has deviated from it's long-term value; avoid pricing it in currencies that are far from constant in either quantity or value.

The change from the 1980 panic spike can be calculated at anywhere between $2200 and $7400 - depending on which measure of inflation is used.

As the measurement of CPI is so politically sensitive and open to constant manipulation; it's safer to gauge gold's current fear premium by comparing what an ounce of gold will buy.

Throughout history, it's said that one ounce of gold will buy a man a high-quality outfit [hat, tie, shirt, suit and shoes] or 400 loaves of hand-made bread. [Not the mass-produced cardboard stuff.]

Work those figures out in any currency and you have a rough idea of where gold would be in settled times. Anything above that range needs abnormal conditions to sustain it - and you should proceed accordingly.

It should also be remembered that the dollar cannot fall to nothing. It is, at least nominally, backed by 8,800 tons of gold - at some point the dollar/gold value must come into equilibrium and the dollar will be a de-facto gold-backed currency again.

Nov 04 03:09 PM

[dctwain:]

Your third chart titled "Real Gold Prices" can be examined this way: In Milton Friedman's book "Money Mischief" Mr. Friedman points out that Keynesian economists had insisted gold would drop to perhaps $6 an ounce. Supply side economists believed gold would rise to $300 an ounce or more, and in 1971 President Nixon cut the last cords that bound us to The Bretton Woods system.
President Reagan cut Taxes, cut regulation of the economy, and slowed down the printing of new money from his inauguration until 1988. Following President Reagan we see an up tick in your chart matching the role of President Bush (41) (read my lips no new taxes, who raised taxes), then President Clinton who signed NAFTA and the growth of a new portion of our economy, the Internet/Info tech. economy. The massive growth kicked off by these events explain the drop in gold prices. In 2000 we had the Dot com bubble followed by the Housing bubble with President Bush (43) and President Obama printing and spending USD at unprecedented rates. Gold will rise over the long term until a new paradigm is achieved.

Nov 04 04:46 PM

[Roger Knights:]

"but in a worst-case scenario it might fall back to $400. That's a very lopsided risk/reward proposition ..."

Asian central banks want to re-balance their reserves in the direction of fewer dollars and more gold, and they have the excess bucks to sop up any gold supply that's offered. They won't let gold fall by more than 10%. This shift isn't a whim or twitch that's susceptible to the Fed's interest-rate tinkering, it's a multi-decadal sea-change. That's all ye need to know.

Nov 04 04:54 PM

[Holmes:]

The dollar has impersonated the role of gold for much too long and now gold is taking back it's true role in the word economy. About time!!

Nov 05 02:26 AM

[gaddiel:]

Banks has their own reserves. By letting it spread to the market will do good and will expand more.

Nov 06 03:00 AM