By Economic Forecasts & Opinions
Gold prices surged to a new high Tuesday on news that India's central bank bought $6.7 billion worth of gold from the International Monetary Fund (IMF). December gold jumped as high as $1,087, before settling at $1,084.90 an ounce on the NYMEX breaking the previous record of $1,072 an ounce on Oct. 14. Prices are now up 22.7% for the year heading for a ninth straight annual increase. (Fig. 1)
Unusual Correlation
Historically, gold moves in an opposite direction to stocks because of bullion’s traditional role as a safe haven in times of crises. But gold has recently climbed in tandem with rising equities. For example, the Dow Jones Industrial Average, a bet on the economic recovery, is up about 15% this year. (Fig. 2)
This unusual correlation is driven mostly by excess liquidity, return of risk appetite, and a weakening U.S. dollar. The creation of the U.S. national marketable debt to a record $7.01 trillion to revive growth, along with the Federal Reserve’s maintaining the benchmark interest rate near zero since December 2008, and the prospect of heavy government borrowing to fund deficits, threatens to weaken the dollar and fuel inflation and increased economic volatility later.
Economic uncertainty, inflation worries and the weakening U.S. dollar helped push gold to a new high this year. Weakness in the dollar benefits gold, which is often used as an alternative asset hedge to a depreciating dollar. The Dollar index (DXY) has declined about 10% this year. (Fig. 2) Right now, the general trend is still for further dollar weakness on the back of the Fed’s easy monetary approach, which will be supportive for the whole commodities complex.
Gurus Now the New Gold Bugs
During the bull market just a few years ago, gold was the last place people would look to put their money in for an asset class. Nowadays, almost everyone from investment gurus to store clerks is either piling into or at least talking about gold.
Fund manager John Paulson increased his bets on gold this year, while David Einhorn of Greenlight Capital was buying gold for the first time. Andrew Hall, the star trader of Philbro, has also reportedly been buying gold this year.
Meanwhile, Paul Tudor Jones, also told clients on Oct. 15 that the time to hold gold is now "as faster inflation and increased purchases through exchange-traded funds, and by central banks boost demand amid stagnant mine output."
Roubini: Gold Has Nowhere to Go
Contrasting to the renewed enthusiasm in gold, Dr. Nouriel Roubini, in a recent interview with IndexUniverse, says gold will go up only for two reasons: inflation or another Armageddon depression.
He indicates that there is currently no inflation risk, as we are still in massive deflation due to a glut of capacity, weak demand, and high unemployment. He went on to say that we’ve also avoided the “tail risk of another depression.” So, without inflation and depression, gold likely has nowhere to go in the next three to four years.
Dr. Roubini did conclude that there is “a wall of liquidity" chasing assets, and a correction could be coming in risky assets with an anemic recovery.
No Inflation & Avoided Depression?
The warning of a deflationary threat from many mainstream economists such as Dr. Roubini suggests a group-think mentality that the output gap and anemic economic growth would keep inflation low (in the next three to four years, according to Roubini), in spite of central bank policies creating massive monetary inflation this year.
But Dr. Roubini’s assertion that we face no inflation risk, AND at the same time avoided another depression in the next three to four years seems to defy logic. The “no inflation risk” assumption is a recessionary scenario, if prolonged, would lead to depression, i.e. the W-shaped double dip.
On the other hand, if we have averted another Armageddon depression, which implies resumption of growth. Economic strength typically leads to inflation with everybody chasing assets. Ergo, there is got to be one or the other, i.e., we should either have inflation; dip into recession/depression or…both, most likely before the end of year 2011.
Money Supply & Velocity Spells Inflation
It is well established that there is a positive correlation between the money supply and inflation. The amount of dollars in the system has increased dramatically. (Fig. 3) But the inflationary pressure from the “wall of liquidity” has been offset by a decline in the velocity due to reduced economic activity and tight credit conditions. (Fig. 4)
This reduced velocity in money is part of the reason why when stripping out the two stimulus plans, cash-for-clunkers and the home buyer tax credit, the U.S. economy grew a mere 1.64% in the 3rd quarter, with quite a subdued U.S. consumer and underlying producer price inflation data.
However, based on the latest Federal Reserve data, the decline in velocity seems to be ending. (Fig. 4) If the reversal trend takes hold with an improving GDP outlook, we are likely to see renewed growth in the price inflation level.
Gold Should Be at $2,300?
The fast ascent to new record highs this year has some of gold proponents worried it might be getting ahead of itself. But on an inflation-adjusted basis, the prices of almost all commodities have reached their 1980's level, except for gold and sliver. On that note, gold would have to double to $2,291.55 to reach its 1980`s high, which its supporters believe means gold could go much higher.
Confidence Lost at Central Banks
In addition, many U.S. creditors have fundamentally lost confidence in the US dollar and are incrementally diversifying into hard assets and non-dollar currencies. There are indications that China, for example, could be shifting to a partial gold standard through reserve accumulation.
The Reserve Bank of India (RBI) yesterday said it had bought $6.7 billion worth of gold from the International Monetary Fund (IMF). The purchase RBI made is nearly half the 403.3 tonnes gold that the IMF decided to sell in September to raise resources for lending to low-income countries. Most speculate that China would be the buyer for the remainder of the gold for sale by the IMF.
The deal represented one-eighth of the IMF’s total gold stock. This is the first time since 2000 that the IMF has sold gold to a central bank. India's affirmation of current gold prices is a big sign that the nation sees the recent surge in gold isn't likely to abate any time soon. It also signals that the fall in the US dollar seems to be pushing central banks to strengthen their portfolio with gold.
The purchase will lift the share of gold in India's 285.5-billion foreign exchange reserves from near 4% to about 6%, which is much less than most of the developed world and four times China’s. This lower gold to reserve ratio also suggests the China and India could continue to be the buyer in the gold market.
More than Just Skin Deep
There are others who are concerned that the relatively high prices of gold could crimp jewelry demand from India and China, which accounts for two-thirds of the total gold demand. However, culturally speaking, most Asian countries see gold as the ultimate instrument for value preservation. This tends to keep the demand level of gold fairly stable regardless of the price of gold.
Even if the jewelry demand drops due to the high flying gold prices, the current trend is that investment demand for gold could exceed that of the jewelry demand, similar to the trend of the 1970’s. This change primarily stems from the investment community losing confidence in current monetary policies and corporate earnings.
Dollar & Inflation to Support Gold
Of course, people no doubt will keep arguing about whether gold is a legitimate currency. Either way, gold has done well in periods of economic and financial difficulty, such as the 1970s, when the dollar was weak, inflation was high, and confidence in government was low. The weak dollar and inflation perspectives discussed here are enough to support a continuing gold rally for the next few years in the asset class.
Portfolio Strategy
Investors should consider using gold as a way to insure their portfolio by allocating no more than 10% of their holdings to bullion and gold stocks. However, beware that the battered greenback could weigh on operating costs of producers with significant operations outside of the U.S. Companies like Barrick Gold (ABX), Kinross Gold (KGC), Jaguar Mining (JAG), Newmont Mining (NEM) and Yamana Gold (AUY) have substantial operations in Canada, Australia and Brazil, making them vulnerable to a depreciating U.S. Dollar.
# Maybe self-destruction is the answer #