JP Morgan Chief Commodities Strategist Colin Fenton recently joined CNBC "Squawk Box" to talk about gold at $2500. The piece was no doubt confirmation to many precious metals investors as to the expected direction of the market, regardless of the recent gold pullback.
But the conversation was also interesting because Colin Fenton noted a very close relationship between gold and entitlement program spending in a thesis that a reduction in deficit spending would send the gold price tumbling to $1200 an ounce. CNBC Video
Specifically, Colin Fenton had this statement on CNBC:
“If we plot the price of gold against the entitlement spend in the U.S. Federal Budget, it is almost a 1:1 correspondence … “
I pulled some information from usgovernmentspending.com and graphed it against the gold price for the last ten years. As you can see, there doesn’t appear to be a 1:1 relationship. That’s not much of a surprise to me as comparing gold to a specific set of government spending accounts hasn’t traditionally been the focus of gold price forecasting.
Further, Colin Fenton had this prediction to make about the future gold price dependent on U.S. debt super committee decisions.
“Gold could break either way, it could go much higher or much lower, depending on how that [U.S. resolving it’s entitlement debt] works out … If we get something from the deficit super committee that looks alright not but great … that is $1.5 trillion. What we need is $4 trillion. If the debt committee surprises us, and we do get a big number, gold prices will be crushed; we could go down to $1200 or lower. But if the number is closer to the statutory requirement of $1.5 trillion, we’ll get our number [$2500 gold price earlier predicted].”
Since the correlation between gold price and entitlement spending doesn’t appear valid, I question the value of the statement above. I think it is instructive to find better correlations for gold price in determining future price targets.
The first thing I did was compare gold price to money measures, a much more common technique used by market analysts. We get the following graph since 1973.
It appears as though since 1973, the gold price has closely tracked M2 and M3 monetary measures. In other words, there appears to be a close relationship with various money aggregates and the price of the shiny metal in the market. However, there is one caveat to this comparison. The U.S. artificially set the price of gold until 1971 when it was allowed to float in the market. This is when President Nixon ended convertibility of U.S. dollars into gold, in large part due to the flood of redemptions in U.S. paper currency for gold stocks in Fort Knox.
What likely happened, since we know that U.S. monetary aggregates had increased from 1913 to 1971 which precipitated the flood of U.S. dollar to gold redemptions by other countries, is that the price of gold was really undervalued in terms of U.S. dollars. Therefore, in the chart above, we see gold ‘catching up’ to the amount of money in the system. And because there is much argument over which monetary aggregate number actually represents usable currency in the system (and which portion equals credit and relending), I decided to take a slightly different approach to tackling the gold price problem.
I graphed the inflation rate since 1913 to 2011, on a 5 year increment, from data provided by the Minneapolis Federal Reserve.
* Note, because of manipulations to the official inflation rate as per Boskin Commission recommendations, I substituted the Shadowstats.com SGS inflation rate calculation from 1981 onward to reflect a consistent approach to measuring price inflation since 1913.
As you can see in the above chart, the price of gold, once free to float in the market, has gravitated to its inflation adjusted value. That is why we saw the large increase in gold value in the previous chart against monetary aggregates: gold appreciation surged to make up for understatement of gold price due to U.S. price fixing.
It is worth to note here that while gold appears to be fairly valued on an inflation-adjusted basis, we are not done yet in our future price predictions on gold. We know that recently gold traded in the $1900 range. So why did it move so high? Investors also tend to price in future expectations on the price of gold based on current economic trends. $1900 was an expectation of future price levels but the pullback was experienced because the inflation adjusted price of gold didn’t support the $1900 price level, yet.
Price inflation reflects the inflation of the number of currency units printed or otherwise made available for public use against the subsequent increase in economic production. If economic production grows at 2% and money is printed at 4%, then one could expect roughly 2% inflation in prices if all monetary units are released in the market. But in the last few years, not all monetary units have been released into circulation. Many of these monetary units are stored on balance sheets of banks, companies, and even other countries.
In March 2011, it was reported that China held $3.04 trillion in U.S. dollar reserves, which is obviously not a trivial amount. Japan has over $1 trillion in U.S. dollar reserves. Several trillion more are held by various central banks around the world.
In addition, U.S. companies and banks have been holding large amounts of cash in their accounts since the recent economic bailouts threatened the stability of the banking system. While U.S. companies had leveraged highly on debt during economic expansion, they chose to conversely build large treasure chests of cash during current economic malaise to service those existing debt obligations and spruce up their balance sheets.
The Wall Street Journal reported in September that U.S. companies sat on $2 trillion in cash and other liquid assets, up $88 billion from earlier this year. The accumulation of cash and liquid assets continues as the economy stagnates.
In addition, the same WSJ article noted that companies that divulged their foreign exchange holdings were hoarding half of the cash they amassed overseas. Why does that matter? Well as we see in the next graph, pulled from my March article on money, that many countries are actively expanding their money printing programs over the last ten years, some more than the U.S. Federal Reserve.
If all of those dollar reserves get released into markets, then the price of gold should explode upward. In addition, if all fiat money reserves from other countries are also released into world markets, then we can expect much international upward pressure on the price of gold as well.
This is why the markets are expecting future increases, not decreases, in the price of gold. Even if the U.S. government cuts $4 trillion off of entitlement spending, it will not reduce the amount of currency already in circulation. In addition, it will barely make a dent in the $100 trillion in current value of unfunded liability obligations, as per whitehouse.gov .
And since the price of gold is more closely correlated to the amount of money in circulation and not the amount of entitlement spending, any modest reduction in debt by the U.S. deficit super committee will likely have much less effect on the price of gold than predicted by Colin Fenton. If the price of gold falls to $1200, investors would be wise to back up the truck, rent a U-haul trailer, and have the kids wheel over their toy wagons to stock up on gold at a severe discount.