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We were pleased with our estimate for
gold in 2010, having predicted gold between $900 and $1,200 with the
potential to reach $1,500 should some catalyst present itself. On
average gold traded over the high end of this range, but stalled there due to
a sluggish economic recovery and a strong dollar. But late in the year,
with Fed Chairman Ben Bernanke pursuing deflation like Moby Dick, wielding a
second quantitative easing program of $600 billion to harpoon falling prices,
gold scaled up short of our upside outlier estimate. Since the
beginning of 2011, gold has corrected to the pleasure of sharp traders, while
we maintain a longer view for higher gold prices beyond the near term.
Investment demand for gold may have
pushed aside increased seasonal demand by gold fabricators in the fall of
2010. Rather than waiting for gold prices to correct in the spring due
to changes in seasonal supply and demand, it would appear metal prices faded
in the first week of 2011 due to investor year-end rebalancing, profit
taking, and possibly, computerized trading. These non-fundamental influences
may have added to the metal’s volatility, and even more so for that of
mining and metal stocks. Even with this correction, we stand behind our
recent estimate for 2011, of gold trading between $1,300 and $1,500 with potential
to see $1,600 by the end of the year. As in 2010, we remain bullish on
gold for 2011 (well above cost of production for many gold producers;
essential for keeping mining stocks interesting) and are again comfortable
with not offering an outlier at a lower price.
Gold is a Constant, a Useful Measure of
Value, and a Mirror of Societal Progress
The basis for our outlook is aligned
with Friedrich von Hayek’s The Use of Knowledge in Society,
which recognizes that markets are both perplexing and dynamic, and so maintain
a bias toward “day to day knowledge,” over scientific knowledge
that may be useful only for contrived econometric modeling. We have
more confidence offering an opinion beyond the near term, taking into account
the general factors that from time to time have shown to be reflected in the
gold price. This process is not unlike how the early scientist and
philosopher Benjamin Franklin developed and tested a
hypothesis. Franklin utilized a Moral or Prudential Algebra,
listing the arguments for and against, and by identifying offsetting factors
and a process of elimination, produced a reasoned position to test.
Gold is useful as a constant in a
relative world and a measure of investor’s expectations relative to
other assets. It is said that all the gold mined would fill two
Olympic-size swimming pools or equal one third the size of the Washington
Monument. While gold continues to be mined, production is not excessive, and
relative to industrial and other uses, the supply is reasonably constant with
the price moving up and down in relation to demand. The demand for gold may
move lower as supply of competing assets decline, becoming rarer, and/or the
relative demand for these other assets increases. Likewise, the demand of
gold may move higher as the supply of competing assets increase and/or the
relative demand for these assets decline. As world finance moved away
from gold as money as a medium of exchange, and the important attribute of
money (currency) as a store of value has since weakened, the price of gold
may be the best unbiased indicator of the relative strength of global
currencies, non-tangible assets, and the character of nations in general.
Pertinent Factors Influencing Demand for
Gold Beyond the Near Term
Higher demand for gold would be
paramount in its use as a store of value for feared worst case cataclysms. In
an apocalypse, holding physical gold may not be enough. This brings to mind
the old Far Side cartoon of two curmudgeons fishing, with a mushroom cloud
billowing in the background, reasoning that “this means size
doesn’t matter and screw the limit!” In a more practical
setting, ownership of gold is seen as the best hedge against uncertainty,
financial and otherwise. This article, admittedly from a U.S. perspective,
hopes to identify economic trends, which, influenced by U.S. fiscal and
monetary policies, may have a significant influence on the average price and
trend for gold in 2011. As the U.S. dollar is the world’s reserve
currency, this article may be of use from a global perspective.
Gold bears may be looking for gold to
decline in demand relative to increased demand for dollar-denominated
non-tangible assets such as stocks, bonds and even currencies. This
would suggest that the assets underlying those dollar-denominated investment
instruments would be increasing in value. Fundamentally, this would imply
that these instruments would represent assets with increased market share,
expanding margins, profitability and purchasing power. Increased demand for
these assets may also result from the expected cash flows produced by these
assets being discounted, potentially at stable or lower rates. Discount rates
incorporate both specific and general risk, including the risk of inflation
of the currency for which these cash flows are denominated. Clearly,
investors demand a real return on their investment.
The argument against gold seems to view
gold as one asset class among many, as opposed to an asset against which all
other dollar-denominated assets may be measured. This point of view makes it
difficult to see past the illusion of nominal value, as opposed to where all
other dollar-denominated intangible asset classes are actually declining
relative to gold. This perspective can eventually lead to observing gold
as in some form of “bubble.” We do not see gold in this light.
Source: Laffer Associates
We are intrigued by the movement of gold
prices. Our interest over a decade ago was based on the predictive ability of
gold movements foretelling the direction of interest rates. Gold has been
seen as a hedge against inflation, and interest rates can be understood to
encapsulate some form of inflation. With the low interest and inflation rates
over the last ten years, based upon earlier conventional wisdom, one might
not have expected gold to have risen to current levels.
It may be useful to pull out old analyst
reports and economic studies with their backward looking metal price
assumptions to see how far we have come. For both inflation and interest
rates, at least as we understand them today, we are clearly in new territory.
It is interesting to ponder why the price of gold has decoupled from
inflation and interest rates. It may be that these alternative monetary
measures may not be calculated using an appropriately consistent
“basket of goods” or have been potentially managed by monetary
policy leaders.
We again suspect that the rise of gold
prices reflects the increased supply and declining demand for competitive
assets. Our primary focus is for sustained expectations of an increasing
money supply, which, in our opinion, may include both the monetary base and
debt. If the level of gold may be assumed constant, the same cannot be said
for the monetary base or the federal debt, both of which have increased over
the last decade, and even more so since the
financial crisis. This may be exacerbated in the coming year with an economic
recovery increasing the leverage of the monetary base and velocity of
currency in circulation as lending increases. In addition, with
deficits as far as the eye can see, federal debt should increase even with
exceptional increases in tax revenues, and even more so should interest rates
move higher. This perspective anchors our perspective for gold prices in
2011.
Source: Federal Reserve Bank of St. Louis
The Case for Higher Gold Prices in 2011
The Federal Reserve was originally
established in order to transfer the responsibility for avoiding financial
panics from one individual, J.P. Morgan in this case, to the people, or the
U.S. government through a national banking system. That was a time in U.S.
history when the government was weak and banks were strong, as opposed to the
current era where government is strong and banks are weak. The recent
excesses, at a minimum including loose monetary policy, fraudulent loan
originations, and excessive leverage, led to the financial panic of 2008 -
just over one hundred years since J.P. Morgan stepped in during the Panic of
1907.
Source: Laffer Associates
Fed Chairman Ben Bernanke, seeing a
seizing up of credit markets, was quick to respond by expanding liquidity by
expanding the monetary base. This response was similar to successful Fed
actions during the Asian Contagion in 1998 or in anticipation of Y2K. It was
significantly different due to both the size of the action and its
duration. By definition, this suggests that the current financial
situation may be increasingly viewed by monetary policy makers, not as a temporary
“crisis” or “panic,” but a sustained downturn of
prices and economic activity, with the risk of deflation morphing from
recession to depression.
Source: Laffer Associates
The immense increase in the monetary
base would have led to inflation, if not for the seizure of capital markets,
followed by deleveraging and subsequent reduction of economic activity.
We again look to Irving Fisher’s Equation of Exchange which may provide
some helpful insights. The Equation of Exchange is M times V equals P times Q
(MV=PQ), where M represents the current monetary base and V represents
velocity, or the rate at which money circulates through the economy.
The product of M and V quite simply must equal Q, or economic output, which
is the sum of all goods and services transacted in the economy adjusted for
the price of money, denoted by the letter P.
Source: Federal Reserve Bank of St. Louis
The increase in the monetary base
appears to have roughly offset the decline in velocity, though we may have
experienced a brief period of deflation. It would also appear that the
monetary base substituted for leverage provided in the banking system as seen
by the retraction of the M1 Money Multiplier. Quite possibly, while liquidity
was made available for banks identified as Too Big To Fail, credit and cash
contracted for those smaller banks and commercial enterprises lacking deep
pockets and a political lobby.
Following the Money Equation, the
increased monetary base offset the decline in velocity, but was insufficient
to offset a broad decline in economic output leading to a temporary period of
deflation. The increased and sustained monetary base may have led to
financial misallocations or distortions. We would argue both the cause, and
the cure, for the most recent financial crisis is reflected in the
paradoxical increase in the gold price and unemployment; with low inflation
and nominal short-term interest rates.
Source: Federal Reserve Bank of St. Louis
The increasing money supply on the left
side of the Money Equation should balance with the increase in economic
output and/or prices on the right side. To the casual observer, it would
appear that the economy has moved beyond the risk of deflation. If this is
the case, a sustained monetary base with increasing velocity may be
inflationary if not accompanied by economic growth. This is the classic
situation where there may be “too much money chasing too few
goods” and paradoxically we see excess liquidity without a commensurate
increase in economic activity. This is also referred to as a Liquidity Trap.
Source: Federal Reserve Bank of St. Louis
The product of an increased monetary
base and declining velocity was insufficient for keeping the money supply
from contracting from 2008 through 2010. While the economy appears to
have bounced off the bottom, Fed Chair Bernanke remains quite concerned about
the high level of unemployment, especially as it may include a greater number
of the long-term unemployed. In recent comments, he remains unconcerned
about inflation, and having previously listed his ongoing aversion for
deflation, he is proceeding unimpeded with an additional $600 billion
stimulus program.
No Direction Home: What to do about
unemployment?
Setting aside the Money Equation for the
moment, Fed Chairman Ben Bernanke, while subject to the laws of nature, is
also subject to the law of the land. The Federal Reserve is governed by
the Full Employment and Balanced Growth Act, also referred to as the
Humphrey-Hawkins Full Employment Act. The law presumes the relationship
exhibited by the Phillips curve that there is an inverse relationship between
unemployment (slow growth) and inflation (high growth). Since Fed
Chairman Ben Bernanke has recently stated that he has a “100%”
level of confidence that inflation can be contained by available monetary
tools, for his purposes, any increase in the money supply should translate
into an increase in economic growth. In other words, don’t worry,
be happy.
Source: Federal Reserve Bank of St. Louis
It is difficult to imagine the economy
growing while the labor force is declining in the aggregate or the labor
force is declining as a percentage of the GDP. More alarming is the
increasing level of unemployed for longer durations. Fed Chair Ben Bernanke
is rightly worried. He stated, "The aspect of the unemployment
rate that really concerns me is that more than 40% of the unemployed have
been unemployed for six months or more, and that’s unusually high. And
people who are unemployed for such a long time - their skills erode, their attachment
to the labor force diminishes, and it may be a very, very long time before
they find themselves back in normal working position.” While
payrolls increased about 103,000 in December, 2010, this was less than the
200,000 needed for sustaining growth. Worse yet, the decline in the
unemployment rate was attributed not to the increase in payrolls, but to the
260,000 unemployed believed to be giving up seeking employment and no longer
counted in the unemployment rate.
Source: Federal Reserve Bank of St. Louis/Bureau of
Labor Statistics (seasonally adjusted)
The increase in duration of the
unemployed, those seeking employment, is leading the nation into uncharted
territory. While concerns are raised regarding the independence of the
Federal Reserve, presumably by those who may be concerned about loose
monetary policies leading to inflation, the Humphrey-Hawkins Full Employment
Act eliminates any true independence. The Act requires consideration of a
number of economic issues that may lead to policies in opposition to monetary
stability, which is an important characteristic of money as a medium of
exchange and store of value. In any event, Fed Chairman Ben Bernanke
has a perspective grounded in the belief that the Depression was due to a
tight monetary policy and he may personally hold an aversion to being left
holding the bag should the economy double dip into a lengthy economic decline
linked to deflation. From this perspective, the Fed Chairman is legally,
academically and personally predisposed to carry out the purchase of $600
billion in Treasuries.
Gold Outlook for 2011: the glass half
full
There seem to be hints of a new fiscal
conservative wind blowing in the U.S. for federal, state and local
government. The extension of the Bush tax cuts may only help head off a
decline in the national economy, but even a change in the U.S. House of
Representatives may be insufficient to reduce spending or regulations which
may retard economic growth. This situation is likely to persist beyond 2011.
According to the Money Equation, should the money supply increase faster than
a growth in output, inflation should ensue. This suggests that a period of
stagflation with both high unemployment and inflation is ahead.
 
Source: Federal Reserve Bank of St. Louis
To stimulate the economy, the Fed
Chairman Ben Bernanke is well disposed to hold down short-term interest rates
through open market policies. This helps banks to borrow short term on the
cheap and realize higher margins to build capital, leading to a healthier
banking system. In addition, the loose monetary policy and low rates
may buoy the real estate markets, helping banks with large real estate
exposure move more solidly into the solvent category. Consequently, it is
likely that loose monetary policies, combined with the other excesses such as
leverage and fraudulent lending practices, led to a “bubble” in real
estate values from 2005 to 2007. With the collapse of leverage in 2007
and 2008, real estate values collapsed but gold continued to move higher.
While the Fed Funds and 3-Month Treasury rates have been flat and near zero,
10-Year Treasury rates, along with 15 and 30-year mortgage rates are moving
higher from record lows.
Source: Laffer Associates
Near zero Fed Funds rates seem to
explain the recent price increases in commodities such as gold. This
relationship appears consistent over the last decade and one may easily
conclude that the extended periods of low interest rates may lead to higher
commodity prices. Given our read on Fed Chairman Ben Bernanke, and calls for
Federal Reserve independence during a political period still dominated by
legislative proponents of additional stimulus programs, we don’t see a
change of course in 2011. Gold bugs should be very wary if Fed Chairman Ben
Bernanke acts upon his threat to increase interest rates (including foreign
buyers of U.S. debt). Knowing that higher interest rates may derail an
economic recovery, the question investors should concern themselves with, is
will he (or does he have the nerve to) pull the trigger on higher interest
rates?
Higher interest rates are important in a
functioning economy for efficient capital markets to discipline borrowers and
reward investors and savers. Our fear for the economy is that the longer
interest rates are artificially suppressed, the greater the likelihood of
inflation, and more painful the remedy. Higher interest rates were necessary
to drive inflation out of the economy in the early1980s. Recently, the U.S.
has enjoyed the best of both worlds - a strong dollar to the Euro, and a
cheap source of products from Asia. The odds of this temporary happy state of
being to change over the long run are very good.
The Moral and Prudential Algebra for
Gold in 2011
It is reasonable to assume that the
aggregate supply of gold should remain relatively constant in 2011. Having
increased the monetary base, the Federal Reserve plans to continue its
program of buying Treasuries to stimulate growth. With some improvement in
consumer confidence and bank lending, the velocity of money is increasing.
Combining the monetary base with the velocity of money, the money supply is
likely to expand in 2011. The uncertainty of government regulations may
retard economic growth for all but the largest of companies and, with an
increasing level of long term unemployed, may place a drag on the economy.
The level of government debt is likely to increase, absorbing cash stimulus
by the Federal Reserve. The sum total of these proceedings should increase
the total amount of dollar denominated assets, which could lead to even
higher gold prices in 2011.
Mike Niehuser
Beacon Rock Research.com
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