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.
(Copyright 2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
sales, syndication and
republishing.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
