Gold And Deficits - The Connection Might Surprise You

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 |  Includes: GLD
by: Ben Kramer-Miller

Summary

Investors often assume that large deficits are beneficial for gold.

Historically, more often than not the opposite is the case as demand for interest bearing assets generates demand for Treasuries, which gives the Government the green light to borrow more.

There are exceptions to this, and investors looking for a stronger correlation to follow should look at the correlation between gold and interest rates.

I recently wrote an article in which I discuss the correlation between interest rates and the gold price. In response it was brought to my attention that we could see a similar correlation between the budget deficit and gold prices.

Intuitively one expects that there should be a correlation. If the budget deficit is high then debt is a less attractive asset, and this would be favorable for gold. Similarly if the budget deficit is low or non-existent, then investors would have more faith in the value of the debt and in the dollar. This would make gold a less attractive asset.

However, this intuition is historically unfounded.

Let's examine this intuition and consider the historical data. It doesn't make sense to look simply at a chart of the deficit because the deficit is a relative statistic. So I've decided to locate a chart that shows the relation between the deficit and GDP.

We see that the budget deficit-to-GDP ratio is relatively high in the mid 1970's, around 1983, 1993 (signified by dips in the chart above). Then it gets out of control starting in 2007 and it is still at an historically high level with a deficit greater than 7% of GDP.

On the other side of the coin, we can see a smaller deficit or even surplus in 1969, 1974, 1980, and around the turn of the century.

Now compare this to a long-term gold chart.

Click to enlarge

(Source: GoldRateForToday.org)

Looking at this chart we can see points at which this intuition makes sense. The most glaring of these is the surplus period from about 1998 - 2002, which coincides with a major bottom in the gold market.

But we also see several where it does not make sense. The first is in 1969. While the gold price was technically fixed at $35/oz. this wasn't really the case, as is evidenced in the following close-up chart (1968-1971).

(Source: Mises.org)

Here we see a peak in the gold price in 1969 while the U. S. generated a slight budget surplus, although this surplus quickly dissipated.

During the first part of the gold bull market in the 1970's--which really began to take off in 1972--we see in the above chart that the budget deficit shrank slightly. We can also see that the gold price fell as the budget deficit worsened slightly in the mid 1970's, and as the budget deficit shrank in the latter part of the decade the gold price soared. In fact 1980 was a major turning point for both the gold price --which peaked--and the budget deficit--which bottomed as a percentage of GDP.

In the 1980's we see a similar trend that runs counter to our intuition--the gold price falls into 1983 while the budget deficit grows in relation to GDP. We then see consolidation in both the gold price and the deficit/GDP ratio until 1993 (but keep in mind that the gold price did hit a slightly lower low in 1985 than it did in 1993).

From 1993 - 2001 the deficit shrank considerably, and yet the gold price hardly budges.

Finally as we get to the modern era we see that the gold price rose in the post tech-bubble era while the budget deficit shrank, and both reversed in 2008 before the late-summer panic.

What this tells me is that counter to our intuition there is more evidence that large budget deficits coincide with a falling gold price, and vice versa. Furthermore, given the substantial reduction in the budget deficit in the 1990's with very little movement in the gold price one might even argue that there is no correlation.

However, given the rest of the data it makes sense to consider this period to be anomalous and to settle on the conclusion that a small budget deficit coincides with a high gold price and vice versa.

Why?

While at first this may seem to be counter-intuitive I think the explanation is pretty straightforward. We saw in my previous article that as interest rates rise the gold price rises as well. This is the case because as interest rates rise investors are less attracted to interest-bearing assets and they choose gold and other assets with intrinsic value as alternatives. At the same time rising rates force the government to cut down on its borrowing. Similarly as rates fall demand increases for interest bearing assets while it falls for gold, which doesn't generate any income. As a result the government can borrow more money without dramatically increasing its interest-burden.

In short a low interest rate generates demand for interest bearing assets and this increased demand enables the government to borrow more. Similarly a high interest rate generates a flight from interest bearing assets and the government is forced to pull in its horns while gold and other hard assets benefit. The point of connection between the deficit and the gold price is interest rates, and therefore I think gold investors would be wise to focus on this statistic. The deficit isn't irrelevant, but it is certainly secondary with respect to our understanding of what drives the gold price.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.