Gold: Faster, Higher, Stronger?

What will the gold-dollar exchange ratio be in the future?  Both trade hyperactively on currency desks.  Thus gold is a physical commodity that acts as a currency.  It is a hybrid.  Is it really money, as many adherents claim?  Should it be?  Certainly that topic accounts for the rise in the gold-dollar ratio in past years.  There are arguments both in favor and against that proposition.

Historically, an inconvenient truth about gold is that gold standard periods have on occasion been associated with inflation:

An additional impact of gold rushes of the nineteenth century was on prices. Because precious metals were at the base of the monetary system, rushes increased the money supply which resulted in inflation. Soaring gold output from the California and Australia gold rushes is linked with a thirty percent increase in wholesale prices between 1850 and 1855. Likewise, right at the end of the nineteenth century a surge in gold production reversed a decades-long deflationary trend and is often credited with aiding indebted farmers and helping to end the Populist Party’s strength and its call for a bimetallic (gold and silver) money standard.

Today, if the major countries went back on a gold standard, the above  possibility looks less likely as so much refined gold now exists aboveground and cheap supply is so constrained, but the point remains that over time, a gold price well in excess of the cost of finding new gold will act as a brake on gold’s price.  Even though gross profit margins for gold miners are now historically high and mothballed mines are being reopened- a warning flag- all sorts of estimates suggest that there has been so much price inflation in countries that are “prospective” for gold that the current price of $1722/ounce is either just right or even too low to encourage new exploration- and that is without taking into account the probable further price inflation in the nominal dollar cost of bringing “greenfield” refined gold to the market.  Thus we can ignore mine supply in forecasting gold’s price movements in the short and intermediate term.  Similarly, a future international monetary standard that might replace U.S. Treasury debt might be based on, or could incorporate, gold.  

So I think it is reasonable to consider gold as a real form of wealth which a prudent money manager can consider investing in- as opposed to a concept stock or subsidized commodity such as corn-derived fuel ethanol.  This thinking on gold is in line with the current view of the IMF, the European Central Bank and the United States government.  I think the U.S. public isn’t mentally or emotionally “there” at this point, even though much truly sophisticated and truly big money is there.  A great many people look at gold as little but decoration that has gotten overpriced- bubbly, so to speak.  Is that point of view correct from an investor’s standpoint given the fact that gold has doubled vs. USD’s in only three years, having already more than tripled in the prior seven or so years? 

Here is one way of looking at gold and Federal debt levels, from Resource Investor from July 2011:

Here is a similar way to look at it, from Financial Sense from last month: 

The above charts understate Federal debt.  They omit GSE and other agency debt, for example, which are technically not full faith and credit debt instruments of the Federal government.  

These charts show that the price of gold was higher relative to Federal debt levels not just in the bubble month of January 1980 but for some years.  The price of gold is therefore reasonable in comparison.  (It would be even more reasonable if the rising proportion of GDP taken up by consumer and business debt now compared to several decades ago were given some weight.)  The above correlation, which is not well-known to the public at large, allows one to project that the target of $2000 gold sometime this year that I wrote about last spring, at a gold price well below today’s, is reasonable.  

Why compare gold’s price to debt levels?  Is this a random correlation?

The answer takes us back to the point in the lede:  gold trades primarily as a currency.  And remember- increases in money supply are nowadays supporting deficit spending by central governments.  Central banks are increasing the money supply at rapid rates via “quantitative easing” and subtler but more-inflationary-than-not maneuvers such as “Operation Twist”, unbacked currency swaps and the like, thus allowing highly-leveraged governments to leverage further via electronic “money-printing”.    

Are the ongoing episodes of “money-printing” by central banks and the ongoing trend toward negative real interest rates relevant to the price of gold?  I think that they are (not an overly controversial view, but not everyone agrees).  If so, why wouldn’t all that sort of stuff already be priced in?

 It probably comes down to one’s view of the U.S. and major European economies.  My view since pre-Lehman is that there were very large capital deficits.  In that context, the “quantitative easing” etc. have come as no surprise.  The lack of major sustained price inflation, predicted for some time by several economists and bloggers, supports that view.  Real capital, which is now of the fiat nature except for gold, was destroyed massively in the booms of recent years and decades and is now scarce.  It is being replenished, but my guess is that more money-printing and more price inflation lie ahead than are priced in to gold.  Note that this is not identical to the famous “QE to the nth”  phrase of Jim Sinclair.  Regular readers know that I have adopted the view that “biflation” rules.  Some prices rise, others fall; net-net, the cost of living rises.  In this paradigm, Treasurys are bid up in price when disinflation/deflation moves to the fore- which can occur even without much recessionary action due to withdrawal of leveraged transactions; and gold takes the lead when price inflation predominates in the ZIRP world.  We have- sort of- been here before, after the 1929-33 crash.  Price inflation waxed and waned, but so far as actual price deflation- very rare.  But the authorities sustained ultra-low interest rates for a quarter of a century.  I think they might be able to do it again, recapitalizing the system once again.  Thus I think there can be negative real interest rates for years to come, and that possibility is not “in” the gold price.

From a timing standpoint, sometimes it’s better to be early than miss a further move upward. 

A meaningful correction has already occurred:  Gold’s price is now below the price of six months ago.  This has rarely been seen since gold bottomed in 2001.  There were the post-Lehman months, and otherwise there were a small number of times following price surges of gold in which the price was modestly lower half a year later.  In addition, gold’s price vs. its moving averages is, as they say on the Street, “constructive”.  Some sentiment survey show a good deal of optimism,but I hear of slow sales of bullion.  Low trading volumes in the gold funds GLD and PHYS are consistent with apathy and indecision toward gold.  Thus there is plenty of room for the public to get excited again about gold. 

Americans are not thinking much about gold now, even though six months ago they were.  Then, the media was scaring people over the faux fight over the debt ceiling and the real but long-term issue of the S&P Federal downgrade.  Re their investments, Americans are, as usual, thinking about stocks and real estate.  (Many people think there is only one stock- forget the thousands of others!  All of you know which one I mean.)    Are both long-term bear markets over?  That is their question.  Gold is simply not close to being a mainstream investment in the United States.  Thus it can still be considered as under-hyped from the standpoint both of truly big money- think pension funds- and the “average” investor.  

One other important consideration that is separate from the above comes from the concept of currency wars- though I think of it not as war but instead more as managed competition in which the U.S. is both a competitor and the referee.  The U.S. government claims ownership of about 25% of the world’s monetary gold.  Add in the NATO allies, and together one gets to more than 50% of the world’s monetary (governmentally-owned) gold stores.  A high and rapidly rising price of gold would make it very difficult for an aspirant to financial great power status to accumulate enough gold to be a contender.  So, perhaps it is in the national interest of the United States and its western allies for the price of gold to rise, rise a lot, and rise rapidly. Perhaps adding to the demand for gold is a patriotic effort for an American.

It’s an Olympic year- and  of course, the Games are being held in the center of the global gold market.  Citius, Altius, Fortius for gold?

I’m well past my athletic prime, but I’m still betting that’s the case at some point in the not-too-distant future.  But not just for personal benefit.  For the good of the good old U.S.A.


(Note:  Long gold.  The above represents commentary- not investment advice.)



7 comments to Gold: Faster, Higher, Stronger?

  • Hans

    When government destroys the underlying script, it is replaced by something else; in this case it is Au…

    Nicely done on the framing of the charts, Dr X! BTW, I am sure that BOCO and the gang, will use the first chart in their fall campaign..

    The other chart that should have been included, is the falling value of the four other currencies…Gold is rising against virtually all world scripts…

    PLEASE, PLEASE, I urge all to read Mr Wallison’s theory on how this debt mess will play out…Written for the layman (and laywomen) in a concise seven page format…

    It is well worth the registration…

  • CD

    Good article and informative charts. My only disagreement is with the statement that governments maintaining ultra-low interest rates for decades will re-capitalize the system. Governments maintaining artificially low interest rates causes malinvestment and capital destruction, which is what got us to this point in the first place.

  • JR

    “Historically, an inconvenient truth about gold is that gold standard periods have on occasion been associated with inflation”

    I think this is nonsense. The inflation was due to the rapid increase in bad credit that occurred concurrently with the gold rushes. Quantity has little if anything to do with value, of gold or otherwise.

    Value is derived from quality & only gold has the constant quality which allows it to extinguish all debt, always, and so it is money.

  • JR: Surges in gold supply in the 1800s were equivalent to unrestrained printing of fiat money in the past 100 years. Prices surged to keep up with the increased money supply. Per the quote I provided. But that was then. Those days are gone. The case for gold is thus stronger now than before, as I went on to say.

    • JR

      “Surges in gold supply in the 1800s were equivalent to unrestrained printing of fiat money in the past 100 years.”

      I’m afraid not DrX. Gold is gold, its quality does not change, unlike credit. The thing you need to understand about money is that demand for it is, for all intents & purposes, infinite. You simply cannot have enough. When considering money, quantity is irrelevant. Value is derived from quality.

      Gold is money because it alone has the quality that will extinguish debt now, tomorrow & forever. The quantity of gold is irrelevant when considering its value.

  • austrian

    Agree with JR. Dr – may be ask this question:
    Is it possible to buy too much gold?

    Answer would depend on whether you think buying gold is consumption or ‘deferred consumption’. I think it is ‘deferred consumption’, therefore no such thing as ‘too much gold’. Human desire for gold cannot be satiated, even with so much gold above the ground and the stocks to flow ratio is so high (80:1).

    So, the quality of gold stems from the human consciousness and it *seems* like it does not diminish ;). I say *seems*, because all value is subjective anyway.

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