Gold's Glitter Not Yet In Jeopardy

Includes: GLD
by: Shiv Kapoor

Gold Prices a Bubble?

This chart shows the nominal annual average price of gold and the nominal annual return from gold. Gold is more expensive than ever before. But this says nothing about whether it is a bubble; almost everything is more expensive. The nominal annual returns on gold are high, but certainly not at a level where a bubble at the point of implosion is evident.

This chart shows the real (CPI-adjusted) annual average price of gold and the real annual return from gold. The average annual real price of gold is higher than it has ever been before. Gold is over-valued, just as US Treasuries are, yet this does not indicate a bubble on the point of implosion. An annual real return spiking to 50% or more would be cause for concern. I would get wary of a peak in gold prices when over $1,850; continued strength above these levels caused by safe haven premiums would indicate a next risk area of $2,400.

Market in Constant Imbalance

First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity. -- George Soros, The Crisis & What to Do About It.


Bubbles thus have two components: a trend that prevails in reality and a misconception relating to that trend. The simplest and most common example is to be found in real estate. The trend consists of an increased willingness to lend and a rise in prices. The misconception is that the value of the real estate is independent of the willingness to lend. That misconception encourages bankers to become more lax in their lending practices as prices rise and defaults on mortgage payments diminish. That is how real estate bubbles, including the recent housing bubble, are born. It is remarkable how the misconception continues to recur in various guises in spite of a long history of real estate bubbles bursting. -- George Soros, The Crisis & What to Do About It.

The virtuous cycle between prices, perception, fundamentals and prices started in the gold market in approximately 2000. Gold is perceived as a good inflation hedge and as a safe haven. Its fundamentals are driven by interest rates, real interest rates, inflation, inflation expectations and credit risk. It behaves like a super bond; a perpetual, zero coupon, deep discounted bond, with safe haven status. It behaves in a manner similar to long-maturity German Bunds and US Treasuries. It is these perceptions and fundamentals which drive gold prices. However, for gold, the smaller market size can cause greater volatility and distortions in prices. Rising prices have resulted in more conviction in perception, which has fed through to fundamentals and back into prices.

A bubble is likely in the process of inflating. And there is every chance that this bubble will not explode; rather it may deflate over an extended period of time. When credit risk starts falling, real interest rates will start falling; this is normally good for bond valuations. However, for safe haven assets such as German Bunds, US Treasuries and gold, the real interest rates will rise as they lose their safe haven appeal and premiums; this loss of safe haven appeal could occur with rising belief in credit risk in US and Germany, or it could rise with improving confidence and falling credit risk in other nations (i.e. the need for safe havens reduces). In my view, if the crisis continues to deteriorate, German Bunds will lose their safe haven status as a result of perceived rising credit risk in Germany, leaving US Treasuries as the main safe haven. The relatively small size of the gold market means that it can never be the sole safe haven; it will always be second to US Treasuries.

On the other hand, an improvement in the GIPSI crisis will reduce the need for safe havens, in which case, US Treasuries, German Bunds and gold will lose safe haven status and premiums, because of a reduction in the need for a safe haven assets -- with the loss of safe haven status and premiums, real interest rates will rise and US Treasuries, German Bunds and gold will start the long journey back to normalcy.

Once the return to normalcy commences, a loss in gold is likely, but if inflation expectations are high, the loss, if any, may be muted. Truth be told, after credit risk starts falling, we are likely to see a fairly long period of de-leveraging, during which growth will be meek. And with meek growth, it is unlikely that inflation expectations will be high; thus I expect falling credit risk in the eurozone to be an indicator of a peak in gold, US Treasury and German Bund values.

Once a return to a healthy long term growth rate starts getting built into expectations, we can expect inflation expectations to rise. Here monetary policy will play an important role; if inflation expectations can be anchored at below 2% to 3%, with systematic slow withdrawal of money supply, gold prices will continue downwards; otherwise they will rise again. The timing of a reduced need for safe haven assets, depends on eurozone solutions and US action on implementing the 10 year deficit reduction program; I suspect we may see a continued need for safe havens at least through 2012 and perhaps longer (until EU treaties can be re-negotiated to accomodate some level of fiscal and political union, in addition to the existing monetary union amongst eurozone members). Peaks and troughs can rarely be timed to perfection; Gold could go higher over a 3 year horizon; but over a 15 to 20 year horizon - perhaps, or even most certainly not!

Gold & Inflation

Between 1970 and 1980 gold prices moved up in sync with inflation. Between 1980 and 2000, gold prices moved down in sync with inflation. Since 2000, gold prices have continued to rise despite low inflation. One possibility is that gold prices are predicting high future inflation. More likely that gold's relationship with inflation is temporarily overwhelmed by virtue of its safe haven status - simply put, expectations of low real interest rates for safe haven assets, caused by flight from high credit risk assets, have driven prices of safe haven assets higher.

Gold & Real Interest Rates

In this chart, real interest rates are the annual average price of the constant maturity US Treasury. Gold prices tend to peak as real interest rates on other safe haven assets fall to zero and sub zero levels. Keep in mind that real interest rates in non safe haven bonds are already high; these high real interest rates reflect front pricing of future credit losses; so while the real interest rate may be high, after stripping out credit loss premiums, the real interest rate will be low. The spread between real interest rates on safe haven assets and non safe haven assets is the expected credit loss the markets are pricing for the non safe haven assets.

Gold & Nominal Interest Rates

In this chart, nominal interest rates (not inflation adjusted) are the annual average price of the constant maturity US Treasury. The trend it would appear is that when nominal interest rates are over 5% and rising, gold prices rise; when nominal interest rates are above 5% and falling, gold prices fall. Like in the previous chart, the relationship breaks down during periods when high credit risk, drives money to safe haven assets.

This chart shows how nominal gold prices have moved with nominal interest rates. It makes better sense to look at real prices and interest rates, otherwise relationships are obscured.

Gold Returns & Inflation

The following charts show the relationship between the annual average price change in gold from one year to the next and the annual change in annual average CPI from one year to the next. The last two charts show the relationship between the annual average price change in gold from one year to the next and the average nominal and real interest rates which prevailed in that year.

Current period is looking similar to 1986, when inflation rose and gold prices fell. But I find it hard to reconcile how inflation will rise over 4% in a de-leveraging environment.

Same thoughts as for the prior chart.

Real interest rates are negative. Nominal interest are low. A fall into deflationary territory, or even if inflation declines to below 2%, we will see real interest rates rise. Rising real interest rates is a negative for gold returns.


Avoid safe haven assets where real returns are negative or low (below 1%). Hold short-duration Treasuries with a hold to maturity strategy for liquidity and safety. Hold longer maturity non safe haven assets after carefully considering credit risk; there are long maturity corporate and EM sovereign bonds where real interest rates are high (based on lower than current long term inflation expectations) on account of the flight to safety and the credit risk low.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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