By Edmund Moy and Michael Stojsavljevich
Gold prices have grown in value from the $400 level to over $1900 in the span of 10 years. But since last September, gold has been sliding downward and has been in a holding pattern around $1600 since about October of 2011. What is causing the holding pattern, how long will it last, and once it ends, will gold go up or down?
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Gold Prices Correlate with Fiscal Burden
When trying to forecast the price of gold, the most common methods are to correlate gold to either commodities or fiscal and monetary indicators.
Most commodities like gold and oil correlate well for short periods of time so many assume that oil prices are a good indicator for where gold prices will go. But gold has additional attributes that most commodities do not have: it is a luxury good as jewelry, a financial asset as coins and bars, and is highly liquid. That is why gold prices correlate more closely with fiscal and monetary policy while oil prices correlate more closely with consumer demand and GDP growth.
Which fiscal and monetary indicators correlate best with gold? Inflation, interest rates, and the trade deficit all correlate better than commodities but each has their hard-to-explain divergences.
Evidence suggests that gold and the U.S. federal debt ceiling have the highest degree of correlation as it relates to price levels when compared to all other factors, with accommodative monetary policy acting as a catalyst for growth to those price levels.
Unsound Fiscal Policy + Accommodative Monetary Policy = High Gold Prices?
Sound fiscal policy is a precondition for a strong and stable currency, and stable currency creates low and stable gold prices.
However, unsound fiscal policy usually leads to currency-destabilizing monetary policy interventions such as zero interest rates, quantitative easing, and currency interventions designed to keep currencies artificially at existing exchange rates. Those interventions often result in high gold prices.
While down from $1,900, gold prices are still holding at 400% above a decade ago, which are a result of continued poor fiscal policies and which have been enabled by accommodative monetary policies across the developed world, especially in the U.S. and the E.U.
Gold prices will likely remain at this price level until either the fiscal and monetary policies are fixed - or, as is more likely, made worse.
Sound Fiscal Policy Unlikely
Unfortunately, there are no signs that a return to sound fiscal policy is near. Instead, sound fiscal policy has been replaced by overspending and fiscal mismanagement. In the US, successive trillion dollar federal deficits have grown the federal debt from around $10 trillion to about $15 trillion in the past 4 years alone. The President and Congress are in stalemate with no prospect of a budget, much less a balanced or surplus budget anytime soon.
Europe's widespread sovereign funding crisis will likely grow larger as the GDP in most EU countries contracts to recessionary levels, leaving a larger funding problem for the ECB and IMF. And, despite the erroneous accusations that spending restraint is restraining economic growth, it is the unsustainable fiscal expenditures that are the root cause of Europe's slow growth.
Rounding out the big three, Japan's fiscal malaise drags on, having already created two-decades of lost growth.
Central banks across the globe share the blame as well. In response to the unsound fiscal policies across the globe, central banks have intervened with ultra-accommodative monetary policies which have enabled unsound fiscal policies that would otherwise be unsustainable.
For example, zero interest rates and direct quantitative easing programs like those in Japan and the United States have effectively monetized the fiscal gaps. The ECB is also engaged in a form of quantitative easing via its LTRO program, which is a loan program which delegates quantitative easing measures to the banking industry, expecting them to buy sovereign bonds.
Putting together these fiscal and monetary mistakes, we term these global economic policies "accommodative mismanagement."
And the greatest beneficiary of this global accommodative mismanagement has been precious metals, including gold.
Explaining Gold's Holding Pattern
Why has gold stabilized at roughly $1,600?
Better than expected GDP growth in 4Q 2011 gave pause to gold's upward move because it raised the possibility that increased tax revenues would decrease the annual budget deficit, and thus the national debt would grow at a slower rate.
Now, rising oil prices are limiting the Fed's short term monetary policy tools by raising inflation levels very close to and soon, potentially above the Fed's target rate, which reduces the Fed's ability to deploy new quantitative easing measures and delaying QE3.
Both issues have converged to slow gold's price movement, placing gold prices in an extended holding pattern.
Ending the Holding Pattern
How long the holding pattern will last is uncertain, but we believe three issues may end the holding pattern this year.
First, our national debt will hit the U.S. federal debt ceiling before the end of the year. The administration and Congress will likely approve a new debt ceiling to nearly $18 trillion dollars or more.
Second, if GDP growth slows from Q4 2011 levels in the US, cold water will be thrown on the possibility that our economy will grow enough that tax revenues to close the fiscal gap without having to address unsound fiscal policies. The Q1 2012 disappointing growth is just one data point. Disappointing Q2 2012 numbers could signal that our mediocre expansion has stalled.
Also more EU countries may follow Greece, Ireland, and Portugal into the financial abyss, adding new debt concerns globally and increasing debt financing needs. The numbers just came out for Spain and they do not look good.
Third, to remedy both our slowing economic growth and the president and Congress' inability to agree on a sound fiscal policy, the Fed may have to resort to a new round of quantitative easing and other currency interventions. Later this year, the Fed will have more room to act when inflation expectations come down because of several probable factors: demand destruction in oil prices, margin contraction in consumer goods, lower housing values or lower GDP growth. Also by this time next year, year-over-year comparisons in retail gasoline prices should moderate decreasing inflationary expectations sequentially.
Will Gold Go Up or Down?
Once gold's holding pattern ends, will it go up or down?
While many investment analysts and the Fed have begun a public relations effort to dismiss gold's value, one thing remains true. Sound money is truly the only force capable of bringing the price of gold down, just as it did in the early 1980s.
Under Reagan and Volcker, inflation and elevated commodity and gold prices were corrected not by monetary accommodation and fiscal overspending but by difficult decisions to raise the Fed funds rate to high levels and to cut taxes to stimulate fiscal revenues. The economic policies of the early 1980's stand in stark contrast to today's economic policy of Accommodative Mismanagement, which instead creates upward pressure on gold.
Expect gold to track with how much the federal debt ceiling will be raised. Because this is an election year, expect the debt ceiling to rise to just enough to get through November. But regardless of who wins the presidential election, the debt ceiling will have to be raised significantly over the next few years to accommodate existing fiscal expenditures and slow economic growth.
It seems all too possible that gold prices will push through $2000 within the next 2 years, making gold an important component of any wise portfolio strategy.
Last Thoughts and Investment Implications
Currently, growing consternation in Europe over fiscal budgets and austerity measures has led to an increase in the value of the dollar as a safe haven play, providing an excellent buying opportunity for gold.
However, it is unlikely that our nation's unsound fiscal policies will be corrected anytime soon. It is also unlikely that our weak economy will become a robust economy anytime soon. As our debt ceiling rises to accommodate greater deficits, expect gold to break out of its current holding pattern and rise to levels back over $1600 in the second half of this year.
Additionally, as we get into 4th quarter of 2012 and 1st quarter 2013, inflationary pressures should decline, led by lower year over year oil price comparisons, allowing the Fed to resume a more accommodative position.
When that occurs expect a more rapid rise to even higher price levels for gold. At current price levels, investors should consider diversifying their portfolio to include some gold.
Mr. Moy was Director of the United States Mint from 2006-2011 and currently is an Officer and Board Member of L&L Energy Inc. (NASDAQ:LLEN). He owns gold in his portfolio, has a gold IRA, and is the spokesman for Morgan Gold.
Mr. Stojsavljevich served as Chief Strategy Officer at the United States Mint from 2007-2011 and is currently a Managing Partner at Episteme Advisory Group, a boutique advisory firm.