I remain long gold. However, Thursday's press conference by European Central Bank [ECB] President Trichet knocked holes in my positive gold thesis.
There are currently three legs to the pro-gold thesis:
- There is an ongoing secular increase in demand from Asia. If China’s per capita demand for gold equaled Hong Kong, total demand for gold would be about 4000 tons, more than the entire current demand for gold in the world. Though such voluminous demand from China is decades from happening, if ever, growing wealth in Asia will mean higher levels of Asian gold consumption in the years to come.
- As a response to the collapse of the tech bubble, the war in Iraq, and tax cuts coupled with a strange belief that “deficits don’t matter,” the Federal Reserve and the Bush administration made a conscious decision to let the dollar fall. Excess monetary creation and fiscal deficits are bad for a currency. However, the Fed is nearing the end of its easing cycle and taxes are poised to rise over the next few years as the new administration deals with the Bush deficits. Therefore, going forward, U.S. government policies will limit the decline of the dollar.
- There is a natural boundary to which fiat currencies cannot fall beyond relative to one another. At some point, the decline in the dollar leads to economic stresses in America’s major trading partners, causing currency devaluations around the world. The excess creation of money by the Fed leads to excess creation of money around the world, which supports gold prices.
To some extent, this has happened. Broad monetary aggregates in Europe have expanded by double-digits for much of this decade, as they have in Russia, the Middle East, China and many other countries. This partially explains why gold has risen in all currencies, not just against the dollar.
However, Trichet’s comments may be a game changer. If the ECB is going to abide by its mandate to focus solely on inflation (which seems to shock the Bubblevision perma-bulls such as Jack Bouridjian), then rates may be on the rise in Europe. If so, then rising rates in Europe knocks out the third leg of the gold bull argument.
I have heard gold bears argue that a rising dollar is bad for gold. If this were true in isolation, then gold would not have risen in other currencies. However, gold is up in price in all currencies.
What matters for the price of gold is not the relative value of the dollar (at least not in the short run). What matters is why there is relative strength or weakness in the dollar.
If the dollar rises because the U.S. is undertaking policies to strengthen its currency, that is bad for gold. If, on the other hand, the dollar rises because its’ trading partners are undertaking policies to weaken their own currencies, that is good for gold.
Put another way, if all the central banks around the world are easing, that is positive for gold no matter what the relative value of fiat currencies are. If, however, all the central banks are tightening, that is negative for gold, again no matter what the relative value of the fiat currencies are.
Given Bernanke’s speech a few days ago defending the dollar, and Trichet's comments on Thursday, taken at their word, this is ultimately bad for gold because it signals global monetary tightening. The price of gold in dollars may rise as the dollar falls against the euro on Trichet’s comments, as it did on Friday, but structurally, the ceiling for gold may now be limited, as it may be for all commodities.