Gold and Interest Rates

Gold prices falling while the dollar rallies and heads straight up.  What is wrong with this picture?  This has been a rough 4 four months for anyone with interest in gold. The economy is in turmoil, the Fed is printing money as fast as they can and yet gold is slumping.  It’s as if we have entered a  “bizzarro” world where everything is backwards.

Gold has been swept up in the panic selling of late,  but if we step back and take a look at the big picture, gold is down 7.3%  so far this year. (Keep in mind that I am referring to the price of gold, not the gold stocks which have been beaten up like all the other stocks on the market.) This is a dramatically better  performance than virtually all other classes of investments and shines when compared to the S&P 500′s  dismal 40.7% loss.  Still, being down less than other assets is no consolation and many gold investors have been shaken by this.   If gold is not performing as it “should”, we have to ask why?

What is causing this dollar rally and fall off in gold prices?  The answer sheds a lot of light on what is currently occurring in the market.  Capital fleeing out of the bond and stock markets is pouring into US Treasuries at, to date, unheard of rates.  While Treasuries aren’t yielding much, at least they protect capital from the economic implosion occurring globally.  We are entering into a new financial era where return of principle is far more important than return on principle.

Because this downturn is a global event, foreign investors first had to buy US dollars in order to invest in the “safety” of US Treasuries. This panic selling of assets of all types, including gold stocks, propelled the dollar upward as money flowed into US Treasuries which in turn drove down gold futures.  This appears to me to be a knee jerk reaction.  Markets are in turmoil, so turn to the dollar as a safe haven.  It’s a learned response that has been driven into everyone’s head over the last sixty years.

Times Have Changed, This is Not Your Grandfather’s Recession/Depression

Well, this is a different time, with different conditions.  The Fed has declared “quantitative easing” to be the policy of the day and is printing money like it is going out of style and quite frankly, it probably will as we know it today!

The Fed is close to zero “real” interests rates as they embark on this spending spree to right the economy.  When you subtract inflation out of the return on bonds there is very little incentive to stay in for any length of time.  Investors will soon realize this across the globe as the massive influx of new dollars into the global economy feeds inflation and lowers returns even further.  On that date the next reaction will be to the only asset class that is rising in price and that will be gold.  Whether physical gold or gold stocks lead the way this time I can not say for sure, but my gut feeling is that the physical will lead the stocks due to the panic in the stock market that currently prevails.

Adam Hamilton’s comments written on Dec, 5 2008 put it pretty clearly.

Would you loan money to anyone if you knew you would take a real loss for doing so? Not if you are rational. When nominal interest rates are forced so low by central banks that real returns plunge negative, debt investing becomes a losing proposition. In such a hostile environment, debt investors gradually turn to gold. While bonds guarantee them a real loss, gold will at least keep pace with inflation to preserve the purchasing power of their capital.

To understand the interaction between real rates and gold, you really have to take the long view. Since it takes years for investors to perceive the impact of inflation and change their behavior accordingly, gold doesn’t react overnight. But eventually react it does, and this is very clear over a long-enough time slice. The longer real bond returns are poor or negative, the more capital gradually takes refuge in gold.

As conditions deteriorate, more and more people will seek the safe haven of gold.  As prices rise with more and more individuals buying the physical gold the profit margins of the miners will increase, making them more and more attractive to funds.  Fund purchases will ratchet up the price of the gold producers.  Investors will then move into the only asset class with consistent profits. At that point the “gold rush” will be on!

Let’s take a look at a few quotes from James Conrad in his post dated Dec. 4, 2008, “The Manipulation of Gold Prices”.

“The Federal Reserve must now make a tough choice. In the past, Federal Reserve Chairmen may have felt it necessary to support regular attacks on gold prices to dissuade conservative people from putting a majority of their capital into gold. Now, however, the world economy needs much higher gold prices in order to devalue paper money, not against other currencies in a “beggar thy neighbor” policy, but against itself. This can jump start the system. If the Fed continued to support gold price suppression, that would collapse the stock market far deeper than they can afford, most insurers will end up bankrupt, and there will be no hope of avoiding Great Depression II.”

“Anyone who reads the written works of our Fed Chairman knows that Bernanke’s long term plan involves devaluing the dollar against gold. This is the exact opposite of most prior Fed Chairmen. He has overtly stated his intentions toward gold, many times, in various articles, speeches and treatises written before he became Fed Chairman. He often extols the virtues of former President Franklin Roosevelt’s gold revaluation/dollar devaluation, back in 1934, and credits it with saving the nation from the Great Depression.”

Those are pretty powerful words that are sending two very important messages. First and foremost, Bernanke is saying that we are on the verge of a depression if the situation is not handled properly and second, gold will be allowed to rise in order to tie the monetary system to a solid pillar.  This is desperation time for the backers of the fiat currencies!

Gold will have it’s day and it is coming sooner than anyone thinks.  I am willing to predict $1,000.00 per ounce by the end of 2009.  My reasoning for this is based on how long I think it will take for the “bailout” funds to start having an effect on the system.  Add to this the effect of the new administration’s stimulus package. It appears to me that we will be hit with 6 to 8 months of “everything is working” before the bottom falls out.

The markets should rally while gold languishes.  $720.00 and possibly $650.00 will be tested before the full effects of “quantitative easing” become apparent.  I use $1000.00 as a minimum fully realizing that any “trigger” events could force gold to greatly exceed $1000.00 in 2009.  I believe that if no “triggers” are pulled, the Fed will try with everything they have to keep gold’s rise limited and orderly.  It will be a very tough job and I wish them well because I do not want to see the wheels come off. The combination of these forces will write the story for gold for the foreseeable future.  If gold is held down for much longer than the end of 2009, the shot upward is going to be greatly amplified.

Take advantage of this temporary decline to scoop up physical gold and to do your due diligence on quality gold stocks.  As we look back on this date in a couple of years, we will see what a golden opportunity this period provided.

Till next time, good luck and good trading!

Also Noteworthy:

• Bernanke = Inflation
• Inflation, Deflation and Patience!
• Gold and the Dollar
• Gold and the $345 Myth
• Fiat Currency Cycle

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