There have no doubt been hundreds articles over the past couple of years that have attempted to explain the seemingly meteoric rise of precious metals prices over the past decade. I have heard many different hypotheses regarding the factors that underlie the rise and fall in value of these shiny metals. None of these explanations, however, have ever quite been satisfactory to me. The most obvious explanation of course, is that since these metals are priced in dollars, they rise in value when the dollar weakens and decline in value when the dollar strengthens. Although the value of the dollar is clearly a major factor, a quick look back at the value of the dollar versus the price of gold and silver shows that this is a very flimsy relationship at best. Others give a 'rule of thumb', saying that precious metals do well in deflationary and very inflationary times, but poorly in times of moderate inflation. This explanation appears to hold more weight, since the metals have done quite well in the inflationary periods of the mid and late 1970's and again in the deflationary period we have just experienced. The problem is that this theory is counterintuitive. How can an asset flourish in such seemingly opposite inflationary scenarios? Also, how can an asset that is priced in dollars do so well in a deflationary environment? There are clearly other factors at work here.
For the precious metals investor, looking at the slope of the curves of gold and silver prices over the last decade would give even the most staunch gold bug serious pause. Intrinsically, we know our government and governments all over the world are accruing debt burdens whose magnitudes will ultimately end in crisis. But how will the end game play out? Will our government continue to use the fed to create money to the point where the world loses faith in our currency, sparking a hyperinflationary period? Or will we finally find fiscal religion and go the austerity route that Europe is painfully traveling? Both scenarios have very different implications for the dollar and the values of precious metals. Most importantly, how can we more fully understand the fundamentals of precious metals, so that we can preserve our earnings and be well positioned for the next chapter our country's history?
After analyzing many factors, I believe the most reliable statistic that determines the rise or fall of precious metals prices is not the value of the dollar, the rate of inflation, or the policies of our federal reserve bank. I believe the most reliable factor driving gold and silver prices is in fact, a combination of all of these factors. In order to test my hypothesis, I gathered a series of monthly values of the Fed Funds Rate, Consumer Price Index, and spot gold prices dating back to January 1970, or January 1969 in the case of the CPI data. For the CPI data, I compounded the last 12 months of data in each month to obtain a relatively smooth yearly rate. I then ʻCPI adjustedʼ the Fed Funds Rate by subtracting the CPI number. This data was then plotted against the closing monthly spot price of gold (red line), resulting in this spectacular chart:
Based on this chart, it appears that there is a strong inverse relationship between the CPI adjusted fed funds rate (blue line) and the value of gold. Moreover, this seems to bridge the apparent disparity between precious metals prices increasing during both deflationary and very inflationary periods. What is the common thread between the inflationary times of the mid to late 1970ʼs and the current deflationary period? It appears that the answer is loose monetary policy. As measured by the difference between the fed funds rate and the rate of inflation, we are in a period of very loose monetary policy. I was somewhat surprised, however, that recent monetary policy is not quite as accommodating as that in the mid and late 1970ʼs by this metric. Interestingly, the raw data shows conditions in this time period that are very similar in some ways to today, while strikingly different in others. For example, inflation was much higher overall in the 1970ʼs, but had two peaks, the first in the mid 70ʼs and the second at the end of the decade. Both of these periods correspond to large increases in the value of gold. Once the Federal Reserve responded to the rate of inflation by tightening monetary policy, the price of gold promptly reverted downward. We have not experienced a similar period of inflation in this past decade, but monetary policy has become nearly as lax as it was in the 1970ʼs. This is what has fueled goldʼs rise from $283/oz to $1421/oz in the last ten years. Even though by the CPI metric, inflation has been in check for over two decades, the recent recession, persistent unemployment, excessive government debt, continued problems in the housing market, and fears of a ʻdouble dipʼ recession have forced the Fed to maintain the Fed Funds Rate at historic lows. You could also argue that two rounds of quantitative easing have loosened monetary policy to an even greater degree than is reflected by the CPI adjusted Fed Funds Rate. Because of this, even in the face of very low inflation and even a period of slight deflation, monetary policy is very, very lax. Despite Ben Bernankeʼs rhetoric, dollars are being pumped into the system on a massive scale, and they will have a real cost in inflationary terms. As long as these factors remain unchanged, I expect precious metals to continue their linear ascent. The big unknown factor here is the rate of inflation. There are early signs indicating that inflation is on the rise, and with the current Fed policies, even a relatively minor increase in inflation could be the catalyst for precious metals prices to become parabolic. Of course, it is possible that Mr. Bernanke could respond to these concerns by tightening policy, but I think that our current administration will be slow to respond given the current state of the economy, fear of a ʻdouble dipʼ, and the other factors listed above. It is for these reasons that I remain very bullish on precious metals in the near term and expect gold and silver prices to continue their recent performances.
Disclosure: I am long SLW.
Additional disclosure: Long physical gold, long physical silver