Is the Gold Rally Really Over?

So, the word on the street--both Wall Street and Main Street--is that the rally is over for gold and other hard assets. It's time to look elsewhere for increasing value, right? Actually, we believe the recent sell off is a blip rather than a reversal of a trend, one which will provide an entry point for those who are paying attention.

Wall Street pundits are cheering last week's $100 sell off in the price of gold, and investors have turned their back on the gold miners, betting on their downfall. Short interest is up 16% for Barrick Gold (ABX), 22.2% for Agnico-Eagle (AEM) and 22.4% for Goldcorp (GG) between the end of February and mid-March.

But here's the problem with this premature requiem for gold: it presumes that the cause of falling gold prices is a change in monetary policy and the start of a bull market in the US dollar. That's a wonderful scenario but not one supported by other events creating pressure on the economy.

First, there's the Fed's 75-basis point cut in a single meeting last week. That's hardly a hawkish move for the dollar. In fact, the Federal Reserve is quickly closing in on the fed funds rate that originally precipitated the commodities rally in the early part of the decade.

Then there is the lending expansion by Government Sponsored Enterprises: FHA, Fannie Mae (FNM), Freddie Mac (FRE) and FHL. Easing of capital requirements and bond purchasing rules for these entities will add around $350 billion to lending capacity.

Let's face reality: moves by the Fed and GSEs to take bad debt off banks' balance sheets don't improve the quality of the underlying assets. Losses will eventually become the responsibility of taxpayers-yet another burden for all of us to carry.

Are we hearing the sounds of more money creation? The eventual sound of the dollar slipping yet further vs. gold and commodities? That's what I hear, despite the earplugs the Fed and the stock market seem to be wearing.

The recent sell-off in metal was due in part to hedge fund/fast money selling, yet keep in mind that gold is still up approximately 10% for 2008 and up more than 35% over the past 12 months.

I just can't see what has changed about the fundamental backdrop for gold. A great investment in recent years, we think gold will continue to trend upward once this short-term selling abates.

Disclosure: Author has a long position in ABX, AEM, GG, none in FRE and FNM

Comments

[chistletoe]

Your article states the obvious ... still there are people who don't want to see that the emperor has no clothes on ... I am delighted to hear about the shorts ... obviously there are still a lot of folks on Wall Street with more money than brains ...

[IntelligentCommentator]

As a holder of bullion, coins and gold stocks, there are only to prospects that make me tremble: that the Fed will learn to print gold or that it will find an inexhaustible subterranean mine of paper dollars.

[mongoose]

They have, IT"S CALLED THE PRINTING PRESS.

[jt]

IC...you say,

"that the Fed will learn to print gold or that it will find an inexhaustible subterranean mine of paper dollars"

They already have...unless you can put a finite value on the number of electrons in the universe!! They don't even print the majority of it anymore...they just make a few keystrokes and there go a couple more BILLION $$$ thru the ether into the Treasury's or some others' bank accts. It doesn't cost them a flippin'... errrrrr... dollar!!!

As a holder of bullion, etc., you WANT them to continue to do that in terms of dollar-price of gold/silver. As an American citizen, or even a citizen of the world, you want them to stop, as a matter of fact, to be shut down completely by our Congress, as Ron Paul has explained to deaf ears, and the lot of them thrown into prison for the greatest fraud foisted upon a nation likely in the history of the world. jt

[Chuck]

Is it possible for the Fed Rate to go into the Negative?
That is.... the Fed will give away money and expect you to pay back less than what they gave you?
...
Bear Stearns Bailout could be one example ?
Then Citi, WB, and MA, V and who knows what else?

[David Lentz]

It never ceases to AMAZE me that the gold bugs can be so obviously of two minds about the subject of "money". They can treat it as exclusively and only printed (physical) cash -- of course an exceedingly tiny minority of the Fed-created "money" is in paper dollars -- and at the same time recognize that credit is money too, or some sort of lesser variant that they don't want to think about too awfully much, 'cause it makes their heads hurt.

You see, once you acknowledge that the Fed creates "money" by extending credit, you are (or should be) pretty much compelled to look at the "supply of money" as encompassing both physical dollars and extended credit (almost entirely extended credit, as it happens).

Or maybe they feel that they can treat credit extended by the Fed as somehow different from credit extended by Countrywide Finance -- yet each will purchase pretty much the same amount of physical assets, on the same dollar basis. The credit extended by the Fed is pretty much interchangeable with any other form of credit, subject to the willingness of the seller to accept it, and its ability to be exchanged for other forms of credit/money.

Money, in whatever form it occurs in, is simply an intermediary between assets.

So when gold bugs look at the Fed's high-speed virtual printing presses whirring away and completely ignore the ginormous vacuum of collapsed credit that they are attempting to replace, they miss the boat entirely.

Hence the disconnect between those concerned about deflation and those concerned about inflation.

The real concern should be how accurate the Fed can possibly be in this endeavor, with the fuzziness about what credit is sound and what is not forced into stark black-and-white contrast by mark-to-market accounting.

If the Fed overshoots the mark, we are left with an abundance of "money", and we get inflation. If the Fed undershoots, we get deflation. With inflation, the value of gold in dollars will increase, but with deflation, dollars will be preferable to gold (or most other hard assets).

The gold bugs had better be hoping that the Fed more than fills the credit vacuum, and should be worrying about the ability of the economy to accept so much Fed credit. Even if gold is worth $10,000 per ounce, it's pretty useless if you cannot buy groceries or gas with it. And once markets collapse, that's the scenario you are left with.

[eric hart]

David,
First you raise some valid points about credit creation. You make a good case that we are facing two options: deflation or inflation. Then you call previous SA community members "gold bugs", which is both dismissive, and implies a certain shallowness of thinking, and emotional response to the markets.

The people I know that invest in commodities are some of the most critical thinkers, and objective analysts I know. Its not dumb money.

I cant speak for the others, but I agree with the author. I read in Barrons in 2001 that gold was only going down because of the coming deflation.

oops.

Soooooo, noboby really knows what the future holds. We might be facing deflation. But that would require several unlikely events to occur concurrently.

Yes, that Japaneese managed to deflate...this is true. But with Bernanke at the helm, as a known and committed inflater, who has written white papers on how to avoid deflation, we are most likely in inflation territory.

The commitment, the knowledge, and most importantly the political will and motive is there to make sure deflation never happens in this country. Elections coming up, significant underreporting of real inflation to hide the governments sleight of hand, the GLOBAL growth in M3 of almost all developed countries at rates well in excess of 10%. Fortyfive, or $54 trillion in unfunded future liabilites of the US Government, the real cost of the Iraq war at $3 trillion.

Great debts typically get inflated away--thats been the lessons of governments of Governments which promise more than they can deliver.

Finally, the bull market in gold and commodities is a GLOBAL phenomenon. Its not confined to the major but contained US debt implosion.

[SB]

I don't think Ben Bernake is dumb, I think he is being forced into it by an even dumber boss.

[john2]

to "intelligent commentator" as of 1971 it cant print gold and as of since the fed was evily created it it does not print anything the u.s. treasury does. in order to trade gold period it has to go through other banks which i would love to go more in detail but for some reason at 5 a.m. memory fails easily.

[David Fine]

David: Enjoyed reading your insights. I guess the challenge that the Fed is facing is a near paralysis in the credit market. They must hope that, as credit activity does pick up, they can slowly reverse themselves so as to avoid fuelling another asset bubble with all that excess liquidity sloshing around. We'll have to see if their policy actions have inflationary consequences in the meantime.

When it comes to paper currency, I am reminded of the old rule of thumb that currency functions as: i) a store of value; ii) a medium of exchange; and iii) a unit of account. As far as gold is concerned, its only possible advantage is that, from time to time, it can be a good store of value (while failing on both other counts - i.e., as a medium of exchange or a unit of account). Even then, when you think about it, it seems rather odd that people should attribute any particular value to gold at all. I guess it comes down to the fact that pure gold doesn't. oxidize and that it is (relatively) scarce.

My own belief is that the USD will continue to depreciate in value over the next little while, leading foreign investors to bid up the price of gold (in USD terms, at least). How high might it go? I have no idea.

[FxConde]

It appears that the Fed is fighting deflation not inflation with the thought that money is the problem when actually credit is the issue. When banks can't or wont loan money, because they don't want the risk, you can create money all you want it will not resolve the issue. Plus the Fed compound the issue by playing with the value of money thus inflating certain due to exchange rates. As the price of gas, food, and other items continue to go up, people will pressed to decide what bills need to be paid. Logically, housing would be first followed by food, power, water, car payments then credit cards. As it gets harder to pay the bills people will not to pay their credit cards thus putting more pressure on the financial institutions to not extend credit. Car payements would be next etc. If the Fed continues to devalue the dollar it will have the net effect of bringing the velocity of money lower eventually bringing a net deflation into the economy. Not pretty at all.

[User 148292]

Gold is a store of wealth(ie surplus resources) during financial meltdown,irresponsible fiscal policies,war and other forms of instability.You may not be able to buy gas or groceries with gold right now but were the potential total collapse ever to occur you can be sure gold would get you whatever you wanted before dollars or anything else made of paper.Paper is only a promise and is not worth anything if the promiser is unable to deliver the promise.Gold however is a physical substance that you can carry around in your pocket and wont evaporate during times of upheaval like for example paper money,share certificates etc.Once the upheaval is over ,sure the price of gold will drop but youll still have the gold for the next upheaval if you keep it.It is liquid internationally and Im sure that you could buy any larger asset with gold anytime any place worldwide.

[User 148292]

One more point on the subject of printing copious quantities of new money .Could this be seen as a form of taxation in two ways1Someone is paying interest to(the government?)or quazi governmental body on all this new money that has just appeared from nowhere2By the devaluation that follows old people ,children and other trusting people are getting heavily taxed by the value of their savings declining.Its a double whammy.If we start to look at the finance houses and banks as an extension of the state or essentially part of the state then the proportion of gdp raised and spent by the government rises dramatically into the realms of sociallism and we all know what happens to socialist(command)econ... is a lot more than a financial crisis it is a crisis in which the size of the state is increasing to unsustainable proportions and complete collapse looks possible in the medium term,similar to the fall of the soviet union.

[Kunst]

The dollar is going to fall, fall, fall....
Inflation will go up, up, up....
Gold will go up, up, up....
That's life in the rear-view mirror.

Look for the USD to strengthen, price inflation to remain constrained, and commodities, including gold and oil, to retreat. At least for now.

Heresy? OK. All the more reason.

Why? We are in a consumer-spending, credit-correcting, unemployment-fearing recession that will get worse before it gets better. Much of the commodities run-up is speculative and will get unwound when it is convenient to the big boys. Don't get run over in the stampede.

Last but not least, central banks have good reason to put the brakes on the collapsing dollar. Want to bet they can't do it -- for now?

[Heyoehkah]

Nice poem Kunst but I could not disagree more with your thoughts on the future. Look for the dollar to lose two thirds of its value over the next 8 to 10 years. Regardless of the lies the Bush administration and the Fed are saying about inflation, anyone that pays attention knows it is running out of control.

The last time we had very bad inflation was the 70's. Paul Volkers cure was 20% interest. Fortunately our small national budget was financed mostly on 30 years notes. What happens now with our debt in mostly short term notes when interest rates are raised to curb inflation? We default.

The only way out of this short of radical political reforms is to try and outrun inflation. To print ourselves into prosperity. Forget that it has never worked in the past.

My money is in gold and silver mining stocks where it is safe and growing much more rapidly than almost all legal alternatives.