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Among
the many opinions expressed by billionaire investor George Soros over the
course of the 2010 World Economic Forum in Davos, Switzerland was his
statement on January 28 in an interview with Maria Bartiromo, host of CNBC's Closing Bell, that
"When interest rates are low we have conditions for asset bubbles to
develop, and they are developing at the moment. The ultimate asset
bubble is gold." New
York spot gold closed at $1085.40 down $1.80, but the
price of gold is not as much about gold as it is about the value of
currencies, particularly the US dollar.
Since
new currency is created through lending activity, very low or 0% US interest
rates and government deficit spending are fueling a US dollar carry trade and
monetary inflation in the US dollar resulting in rising asset prices and
global speculation. According to Zhu Min, deputy governor of the People’s Bank
of China, “[The US dollar carry trade] is a
massive issue; estimates are that it is $1.5 trillion, which is much bigger
than Japan’s
carry trade.” The close relationship of global commodity prices,
particularly the gold price, to the value of the US dollar can be seen by
comparing the changing value of the US Dollar Index to an inverted US dollar
spot gold price chart.
The
inverted gold price chart follows the USDX closely and while the fluctuations
are not strictly proportional the overall trends as well as the peaks and
troughs generally correspond, thus the asset price bubbles noted by Mr. Soros
are reflections in asset prices of both the US dollar carry trade (the
effective value of the US dollar) and, ultimately, of the long-term
devaluation of the US dollar, thus the value of the US dollar in real terms.
An
“ultimate bubble” in gold could be an offspring of the mother of all carry trades, but its
magnitude would depend not only on the effective value and rate of change in
value of the US dollar while the carry trade is booming, but also on the actual,
eventual value of the US dollar (in real terms) after the carry trade has
come to an end. Although the value of the US dollar will certainly
recover to some degree when the carry trade ends, it will remain
significantly lower in value for other reasons.
US
Dollar Devaluation
In
the above mentioned interview, Mr. Soros went on to say that "Some
countries, like the US
and European countries have plenty of room to increase their deficits;
[although] the political resistance to doing so increases the chances of a
double dip [recession] in the [global] economy in 2011 and after that."
Since further monetary inflation as a consequence of government deficit
spending may be necessary to maintain economic stimulus measures and
financial system life support, Mr. Soros anticipates further devaluation of
the US dollar. Devaluation of the US dollar will have both beneficial
and harmful effects on the US
economy.
Devaluation
of the US dollar will reduce the value of debts in real terms, reducing the
overall debt to GDP ratio of the US economy, and stimulate nominal GDP growth
as domestic prices and wages (at different rates) adjust to the altered value
of the US dollar, while at the same time helping to create conditions where
US banks can resume lending to consumers and small businesses.
Unfortunately, currency devaluation also has deleterious effects, such as
higher prices, a loss in the value of savings and a reduction in the real
value of wages. There is also a risk of uncontrolled domestic price
inflation (although prices can be held in check without raising interest
rates by curtailing the flow of money and credit to consumers and small
businesses).
In
addition to reducing the US debt to GDP ratio, devaluation of the US dollar
will lessen the risk of higher interest rates resulting in greater deficit
spending by the US government as a consequence of increased debt service ($145.4 billion in fiscal 2009) since it will
allow the US federal government’s tax receipts grow faster than the
increase in debt service resulting from higher interest rates.
Currently
projected US
federal government borrowing (or, alternatively, quantitative easing) will
maintain downward pressure on the value of the US dollar through the year
2019. According to the US Office of Management and Budget’s (OMB)
baseline projection of current policy, federal deficits will total between $7
and $9 trillion for fiscal 2010 through fiscal 2019 and the US public debt
will grow from $12.3 trillion to more than $16 trillion in 2019. If debt
held by government accounts is included, total US federal government debt
will exceed $23 trillion in 2019, setting aside the net present value of
unfunded federal liabilities based on Generally Accepted Accounting
Principles (GAAP). According to David M. Walker, former Comptroller
General of the United States from 1998 to 2008 and current President and CEO
of the Peter G. Peterson Foundation, current federal liabilities and unfunded obligations total
approximately $63 trillion. As a
result, further devaluation of the US dollar is inevitable.
Disparate
US Dollar Values
Curiously,
the US dollar has two different and diverging values, one within the US
financial system and another in the broad US economy. As a result of
the US financial system rescue, which included purchases of various assets
from banks at book value by the US Treasury and Federal Reserve, the US
monetary base has expanded roughly 150% since the beginning of the global
financial crisis in 2008, but the newly created currency has not filtered
into the broad US economy where, in contrast, deflationary pressures persist.
Although
it is not apparent in the broad US economy, the value of the US dollar has
been dramatically altered and its devaluation cannot be isolated indefinitely
within the financial system independent of the broad US economy. The counterbalancing,
but much smaller, contraction of the broad US money supply, as measured by the M3 monetary aggregate, also cannot
continue indefinitely.
At
some point, the two disparate values of the US dollar (that found within the
financial system versus that found in the broad US economy) will be
reconciled and, unless current policies are reversed, the outcome will be a
substantially less valuable US dollar. The consequences of the eventual
reconciliation will certainly include price inflation in the US, higher US
dollar prices for commodities that are subject to global demand, such as oil
and gold, as well as higher nominal values for US dollar denominated
assets. However, the potential unintended consequences of a falling US
dollar include high domestic price inflation, a further reduction in
international demand for US debt or a collapse in demand, a disruptive
decline in trade, i.e., US imports, or in the worst case, rejection of the US
dollar as the world reserve currency or a hyperinflationary collapse of the
US dollar.
Is
Gold in an Asset Price Bubble?
Diversification
for the purposes of risk mitigation and wealth preservation is a rational
response to unstable market conditions and is not comparable to a market
mania, like the dot-com bubble. Similarly, a long-term shift in asset
allocation favoring one general category of assets over another based on
fundamentals, while it may result in rising prices, does not by itself
describe an asset price bubble.
An
asset price bubble, such as the Dutch tulip
mania of the 1630s, is an irrational and economically
unsustainable investment trend that holds sway over investors only
temporarily and that inevitably collapses violently. Asset price
bubbles end when a tipping point is reached where the awareness of and
tolerance for escalating risk exceed irrational exuberance producing a
panic. So long as the great majority of market participants discount
risk, individual participants may rely on the irrational exuberance of
others. In contrast, rational confidence does not depend on a majority
of market participants behaving irrationally and is based instead on sound fundamentals.
The
view that rising global commodity prices, fundamentally, are asset price
bubbles in various stages of formation unreasonably discounts the risks
associated with financial institutions, governments and currencies. If
we are to learn anything from Iceland, the Baltic states, Dubai, and Greece
it is that if irrational exuberance exists in the financial markets today it
is exactly confidence that is not based on sound fundamentals in financial
institutions, governments and currencies.
In
the 1980 asset price bubble, gold rose from an inflation adjusted low using
constant 2009 dollars of $392.57 per Troy ounce on August 31, 1976 ($104 1976
dollars) to its January 21, 1980 peak of what would have been $2,358.04 in
2009 dollars ($850 1980 dollars), a gain using constant 2009 dollars of more
than 500% in 4 years. The 1980 asset price bubble in gold violently
collapsed in same year, returning to 1979 levels by 1982.
On
April 4, 2001, the gold price would have been $315.78 in constant 2009
dollars, the lowest value since 1970 adjusted for inflation. From that
point, the gold price rose from a nominal low of $255.95 on April 4, 2001 to
a nominal high of $1,212.50 on December 2, 2009 (London PM fix), a gain of
roughly 375% over approximately 10 years (284% using constant 2009 dollars).
Over
the past decade, the US dollar has declined from its 2002 high by roughly 33%
compared to other major currencies and approximately
40% from is 2000 high compared to the Euro. At the
same time, most of the currencies in the major indices have been debased
alongside the US dollar since 2008 for the same reasons, thus the value of
the US dollar in real terms is not apparent from the index alone.
The
alternate US Dollar Indices published by Shadow Government Statistics (SGS) suggest
that the Federal Reserve’s trade weighted exchange index of major
currencies, which includes the Euro zone, Canada, Japan, the United Kingdom,
Switzerland, Australia, and Sweden, may be an optimistic formulation.
The
decline of a national currency, particularly that of a nation with a large
trade deficit, is first apparent in international trade while domestic prices
do not at first fully reflect the devaluation of the currency. As a
result, the prices of commodities that are subject to global demand tend to
rise before the general increase in domestic prices that results from
currency devaluation, thus the prices of commodities such as gold would be
expected to rise faster than domestic measures such as the US Consumer Price
Index (CPI).
The
alternate CPI measure provided by SGS may represent a more accurate method of
estimating the US dollar prices of commodities that are subject to global
demand. The SGS alternate data show accelerating price inflation over
the past decade leading up to the global financial crisis in 2008.
If
the SGS alternate CPI data are applied to the gold price it is apparent why
Shadow Government Statistics’ John Williams stated in an interview with Bloomberg reporter
Pham-Duy Nguyen that if the same methodology of measuring
inflation were used today as in 1980, the 1980 gold price would be equivalent
to $7,150.
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Chart courtesy
of FGMR
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While
gold certainly has enjoyed tremendous gains over the past decade, including
the effect on the gold price of central
bank gold demand, the current gold price, following on
the heels of an unprecedented global financial crisis, has little in common
with the 1980 asset price bubble. The current gold price reflects a
rational diversification into hard assets for the purposes of risk mitigation
and wealth preservation and can be explained in terms of monetary inflation
and associated loss in the value of the US dollar independent of the US
dollar carry trade. The continuing devaluation of the US dollar will
result in a further rise in the prices of commodities that are subject to global
demand, thus the gold price will continue to rise also.
Mr.
Soros is certainly correct in that low interest rates contribute to the
formation of asset price bubbles, but neither the value of the US dollar or
the price of gold depend only on interest rates or on the US dollar carry
trade. The view that a gold price over $1000 per Troy ounce represents
the “ultimate bubble” ignores the ongoing devaluation of the US
dollar, discounts risks associated with the stability of financial institutions,
governments and currencies, and does not reflect confidence consistent with
sound fundamentals.
Ron Hera
Hera Research
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Ron Hera is the
founder of Hera Research, LLC, and the principal
author of the Hera Research Monthly newsletter. Hera Research provides deeply
researched analysis to help investors profit from changing economic and
market conditions
About Hera
Research
Hera Research,
LLC, provides deeply researched analysis to help investors profit from
changing economic and market conditions. Hera Research focuses on
relationships between macroeconomics, government, banking, and financial
markets in order to identify and analyze investment opportunities with
extraordinary upside potential. Hera Research is currently researching mining
and metals including precious metals, oil and energy including green energy,
agriculture, and other natural resources. The Hera
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