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The
continued bull market in the price of gold has been one of the staple
discussions in the financial media for the better part of a decade. But, in
that time, almost no consensus has emerged to explain the phenomenon. If you
ask ten Wall Street pundits to explain the upward movement, you will most
likely get nearly ten different answers.
While
most logically identify global currency debasement as a primary cause, others
say that gold is driven by: fear of economic uncertainty, central bank gold
hording, international political conflict, or the ebb and flow of the Indian
wedding season. The truth is the main drivers for the price of gold are the level
and direction of real interest rates and the intrinsic value of the
dollar.
Most
people (outside of Washington) understand that printing money dilutes the
value of the currency being printed. When a currency drops, the nominal price
of hard assets in that currency generally rises. But the relationship between
gold and monetary expansion is not that simple.
The
act of central bank money printing temporarily drives down nominal interest
rates, while at the same time creating inflation and lowering the intrinsic
value of the currency that is printed. Therefore, subtracting rising rates of
inflation from falling nominal interest rates results in a falling real rate
of interest. Once real rates become negative, the liability of holding gold,
which offers no interest income, disappears. The more real interest rates
fall, the greater incentive for investors to own gold.
However,
sometimes other factors come into play that prevent a debased currency from
losing value against other currencies. It all depends on the actions taken by
other central bankers. Hence, investors cannot divine the direction of gold
simply by determining the state of nominal interests rates in the US or by
the dollar's value relative to other currencies.
This
brings up two questions; should owners of gold fear rising yields on
Treasuries, or a rise of the dollar against, say, the euro? The answers to
those questions can be found by examining whether the rise in nominal rates
is also accompanied by rising real interest rates and if the rise in the
dollar is due to a decrease in its supply.
For
example, back in January of 1977, the dollar price of gold began an epic bull
market, which ended just prior to February of 1980. Gold soared from $135
dollars per ounce to just under $860 per ounce during those three years. This
move occurred while nominal rates were rapidly rising. The yield on the Ten
Year Treasury soared from 7.2% in January of 1977 to 12.4% in February of
1980. But the increase in yield was just in nominal terms because the YoY
change in the CPI jumped from 5.2% in January of 1977 to 14.2% in February of
1980. During that bull market in gold, real interest rates fell from a
positive 2% to a negative 1.8%, despite the fact that nominal rates increased
by 520 bps.
Yesterday's
release from the BLS showed the October Producer Price Index increased by
.4%, while the YoY increase in PPI jumped 4.3%. However, the Fed will most
likely seize upon the month-over-month change in the core rate, which
registered a negative .6%. Bernanke will overlook the largest YoY increase in
PPI since May and instead worry about the deflation anticipated by core
prices. That means he will find cover to print more money, thus - at least
for now - keeping nominal rates from rapidly rising, while pushing inflation
even higher. Real interest rates should fall and the price of gold should
thus remain in its secular bull market. In my opinion, there is little danger
that nominal rates will outpace the increase in the rate of inflation until
the Fed unwinds its balance sheet like it did under Paul Volcker 30 years
ago.
Likewise,
an increase in the value of the dollar against another currency likely
indicates that the central bank of the other country is lowering real
interest rates and diluting the purchasing power of that currency at a
greater pace than the Fed. It does not necessarily indicate that the supply
of dollars is contracting or that our currency's intrinsic value has
increased.
There
will come a time when the Fed's pursuit of inflation causes a massive crisis
of confidence in our bond market and in our currency. A sudden and dramatic
spike in nominal rates would send real interest rates rising and cause
devastation in most markets, including gold. However, because the Fed's
likely answer to such a crisis would be to create more inflation, any
pullback in gold should be muted as compared to stocks, bonds, and other
commodities.
Michael Pento
Senior Market Strategist
Delta Global
Advisors, Inc.
Delta Global
Advisors : 19051 Goldenwest, #106-116 Huntington Beach, CA 92648 Phone:
800-485-1220 Fax: 800-485-1225
A
15-year industry veteran whose career began as a trader on the floor of the
New York Stock Exchange, Michael Pento recently served as a Vice President of
Investments for GunnAllen Financial. Previously, he managed individual
portfolios as a Vice President for First Montauk Securities, where he
focused on options management and advanced yield-enhancing strategies to
increase portfolio returns. He is also a published economic theorist in
the Austrian school of economic theory.
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