I don’t think the question really is what is gold worth but what are currencies not worth. – Shayne McGuire, director of Global Research at the Teacher Retirement System of Texas, October 2009.

My title’s awful pun on a recent Hollywood movie (No country for old men, directed by the Coen Brothers in 2007) represents not so much an environment associated with the lack of places for Austrian economists to hide; indeed it is meant to suggest the opposite result, namely that all users of fiat money will eventually lose faith and turn to the one commodity that cannot be mal-adjusted by central banks, namely gold.

Just over two years ago, when gold was still trading at US$600 or so an ounce, I wrote an article titled In gold we trust (Asia Times Online, September 8, 2007), the title of that article being a wordplay on the motto on all US dollar currency notes (“In God We Trust”). As the precious metal has now gone to new stratospheric levels since then, reaching a high of over $1,118 this week, the question is raised – what is the future?

At the basic level, and before delving into the outlook for financial instruments and their opposite (namely gold), it must be stated quite clearly that this article isn’t about providing investment advice. Rather, it is meant to highlight certain arguments in favor of, as well as against, the notion of using gold as a replacement for everyday financial instruments.

The most common financial instrument of all is the US dollar (see The dead dollar sketch, March 4, 2008). The problem is that the US dollar does not carry the purchasing power associated with currency when that dollar was first granted to you.

In other words, if you were to rifle through grandpa’s old trench coat pockets and find a US dollar note from the 1950s, one can be sure of only one thing – what the US dollar would have purchased in the 1950s would be far in excess of what it could purchase today, pretty much anywhere in the world.

On the other hand, while the price of gold has moved around a fair bit over the intervening period, it is unlikely that you will find many countries in which an ounce of gold today purchases markedly fewer items than it did in the 1950s. At the very least, it would reflect the same purchasing power of an equalized basket of goods (example – an average household’s monthly expenses on food and clothing) as it did back then. In effect, it is a true store of purchasing power.

This is an important distinction to make between any notion of price changes as we look ahead: the point about gold is not whether its price will go up or down; but that the value at the end of the cycle would likely be equal to the same purchasing power as it has today. Likely, not positively.

What do central bankers want?

If the notion of defining what gold is proves difficult, then perhaps a negative feedback loop addressing what other alleged stores of value (that is, fiat currencies) are not would prove useful.

The one thing that fiat currencies are not is a hedge against inflation. The person who is most likely the world’s most cerebral central banker, Mervyn King of the Bank of England, made a remarkable speech on November 11 wherein he stated the bank’s intention to adopt an easy monetary policy over the near term.

As a famously inflation-targeting central banker of the school of Paul Volcker, the former US Fed chairman, these comments were clearly in need of explanation, which King provided:

Inflation has been unusually volatile recently. It is currently 1.1%, having been 5.2% only a year ago. Such volatility is likely to continue in the short run. Inflation is likely to rise sharply over the next few months, to above the target, reflecting higher petrol price inflation and the reversal of last year’s temporary reduction in VAT [value-added tax]. Monetary policy can do very little to affect these short-run movements in inflation. So the MPC [monetary policy committee] must look to the medium term when inflation is determined by the path of nominal spending relative to the supply capacity of the economy. To do that the MPC must restore the level of money spending to a path consistent with eliminating the margin of spare capacity, and ensuring that the outlook for inflation is in line with the 2% target.

Anyone who invests in fixed-income markets will read that paragraph with dread; for those without a full background in the market I would explain as follows: the focus on pushing inflation targeting away from the near term towards an undefined medium term (is that three months or three years?) suggests that the Bank of England is effectively targeting negative real interest rates (that is, the difference between interest rates and inflation is negative).

Let us phrase that again – in effect, the Bank of England would like interest rates (that is, the compensation for the lowest risk financial assets, namely short-term government bonds or bank deposits) to be lower than the running inflation in the economy: a scenario that would push investors to dump all savings in bonds and instead gamble on assets with a positive sensitivity to inflation, namely house prices or stocks.

If you were to own government bonds – 10-year US Treasuries at present yield about 3.5% – and inflation expectations were to rise, the compensation required for holding these assets would need to rise. For example, if you expect that annual inflation in that country would run at 5%, then you would demand a minimum return well above that, say at 6%. Which is another way of saying that anyone holding bonds at 3.5% today (when inflation is running at 1%) will have to see the prices of their bonds drop enough to take the running yields to 6%.

Crudely put, that number is about a 19% decline in prices as an immediate loss.

That figure is not a big problem for a debtor country, which can sell its bonds to a bunch of creditor nations. For the creditor nations, the problem is quite acute because their holdings of the debt will decline in value massively. You may think that’s not a big figure, but think again; for a country like China, with its US$2.5 trillion in reserves, the loss of 19% is equivalent to $475 billion.

Not to put too fine a point to it, that’s a lot of subsidy for the Chinese people to be giving the fiat money crowd.

Nor is the Bank of England alone in expressing these sentiments. I related in last week’s article (See Leverage not level Asia Times Online, November 7, 2009) the views of the Federal Reserve and the European Central Bank in keeping rates constant and policy tending towards an easing bias; this as a lack of confidence in organic economic recovery pushed the major central banks to adopt a simple strategy of creating asset bubbles as a means to escape the current financial crisis.

The proverbial bag holder at the end of this boom-bust cycle would be the people buying fixed income instruments in the major Western economies: in other words, Asian central banks.

This has caused the extraordinary situation of investors losing confidence in the United Kingdom government bond market (gilts), where prices have declined in price despite the most recent bouts of quantitative easing. Earlier this week, the rating agency Fitch issued a statement casting aspersions on the sustainability of the UK’s credit ratings. As Reuters reported on November 10:

Sterling fell on Tuesday after a ratings agency said highly indebted Britain was the major economy most at risk of losing its triple-A rating. The pound retreated from a three-month high against the dollar hit on Monday, after Fitch told Reuters Britain would have a tougher time than the United States in sustaining its fiscal deficit without impacting interest rates or the currency. A further significant fiscal stimulus package could put the coveted rating at risk, it said.

Readers of this site would have seen my earlier articles on the collapsing UK economy (see for instance G8’s first bankruptcy, Asia Times Online, April 25, 2009).

The notion that easy money creates asset bubbles everywhere is therefore questionable, as investors aren’t all that likely to fall prey to worsening credit fundamentals at this juncture. As Tim Price wrote recently in his regular blog, thepriceofeverything:

Gold could, of course, simply be rallying on the back of the generalized flood of liquidity into financial assets. But not all markets are created equal. While the prices of most financial things have been rising lately, the Gilt market has not been invited to the party. Ten-year Gilts have seen their yields spike from 2.90% in March 2009 to over 3.90% now. That equates to a fall in price of over 8%, and has occurred during the period of extraordinary quantitative easing. This begs the question of what will happen to Gilt prices once QE [quantitative easing] ends (if it ever does). But the persistence of relatively low Gilt yields shows how government intervention can support fundamentally unattractive assets, at least in the short term. Government intervention, through QE, has now managed to distort all asset markets. This makes investment of any sort a little like playing chicken with the government. “Greater fool theory” holds that investors make the most of a rising market because there is always a “greater fool” who will end up being the buyer of last resort. The government has proven to be the “greater fool” throughout the financial crisis. Whether government ends up being the “greater fool” after the equity market rally is another question altogether.

Risks for gold

All that said, there are continued risks to the purchase of gold at these levels. Investors shouldn’t lose sight of its zero-yield nature; nor the relative ease with which the physical market for the commodity can be manipulated; and why would anyone want to buy an asset that has almost doubled in price over the past two years?

On November 11, it was reported that one of the world’s largest producers of the precious metal, Barrick Gold, had moved to remove its forward deliveries on gold; in effect removing one of the key impediments to further rises in the price of gold.

Aaron Regent, president of the Canadian gold giant, said that global output has been falling by roughly 1 million ounces a year since the start of the decade. Total mine supply has dropped by 10% as ore quality erodes, implying that the roaring bull market of the last eight years may have further to run … Barrick is moving fast to wind down the remaining 3 million ounces of its infamous hedge book over the next twelve months, an implicit bet on rising gold prices over time … Mr Regent said the company had waited too long to ditch the policy, which has made the company enemy number one among “gold bug” enthusiasts. The hedges oblige Barrick to deliver part of its gold into futures contracts set long ago at levels far below today’s spot prices. – Ambrose Evans-Pritchard, Daily Telegraph.

There is also that little tidbit about rising demand that I mentioned last week (Leverage not level) as highlighted by the purchase by the Indian central bank of 200 tonnes of gold from the International Monetary Fund. Add to the apparent interest from other central banks around Asia, and we could suddenly see all of the available gold being sold by European central banks quite easily absorbed by Asian banks.

Anyone wishing to participate in the heady gold rally should therefore consider the following- it isn’t the price of gold that is worth watching, but rather the value. The difference is in the non-monetary expressions of intrinsic worth; for example, in terms of being able to positively hedge your positions in the fixed-income positions of various countries such as the US, Britain, Japan and France.

This hedging value of gold, against markets that can simply not be hedged in any other form, is the key reason to observe, if not participate in, the market.


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