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The continued
bull market in the price of gold has been one of the staple discussions in
the financial media for the better part of a decade. But, in that time,
almost no consensus has emerged to explain the phenomenon. If you ask ten
Wall Street pundits to explain the upward movement, you will most likely get
nearly ten different answers.
While most
logically identify global currency debasement as a primary cause, others say
that gold is driven by: fear of economic uncertainty, central bank gold
hording, international political conflict, or the ebb and flow of the Indian
wedding season. The truth is the main drivers for the price of gold are the
level and direction of real interest rates and the intrinsic value of
the dollar.
Most people
(outside of Washington) understand that printing money dilutes the value of
the currency being printed. When a currency drops, the nominal price of hard
assets in that currency generally rises. But the relationship between
gold and monetary expansion is not that simple.
The act of
central bank money printing temporarily drives down nominal interest rates,
while at the same time creating inflation and lowering the intrinsic value of
the currency that is printed. Therefore, subtracting rising rates of
inflation from falling nominal interest rates results in a falling real rate
of interest. Once real rates become negative, the liability of holding gold,
which offers no interest income, disappears. The more real interest rates
fall, the greater incentive for investors to own gold.
However, sometimes
other factors come into play that prevent a debased
currency from losing value against other currencies. It all depends on the
actions taken by other central bankers. Hence, investors cannot divine the
direction of gold simply by determining the state of nominal interests rates in the US or by the dollar's value
relative to other currencies.
This brings
up two questions; should owners of gold fear rising yields on Treasuries, or
a rise of the dollar against, say, the euro? The answers to those questions
can be found by examining whether the rise in nominal rates is also
accompanied by rising real interest rates and if the rise in the dollar is
due to a decrease in its supply.
For example, back
in January of 1977, the dollar price of gold began an epic bull market, which
ended just prior to February of 1980. Gold soared from $135 dollars per ounce
to just under $860 per ounce during those three years. This move occurred
while nominal rates were rapidly rising. The yield on the Ten Year Treasury
soared from 7.2% in January of 1977 to 12.4% in February of 1980. But the
increase in yield was just in nominal terms because the YoY
change in the CPI jumped from 5.2% in January of 1977 to 14.2% in February of
1980. During that bull market in gold, real interest rates fell from a
positive 2% to a negative 1.8%, despite the fact that nominal rates increased
by 520 bps.
Yesterday's
release from the BLS showed the October Producer Price Index increased by
.4%, while the YoY increase in PPI jumped 4.3%.
However, the Fed will most likely seize upon the month-over-month change in
the core rate, which registered a negative .6%. Bernanke will overlook the
largest YoY increase in PPI since May and instead
worry about the deflation anticipated by core prices. That means he will find
cover to print more money, thus - at least for now - keeping nominal rates
from rapidly rising, while pushing inflation even higher. Real interest rates
should fall and the price of gold should thus remain in its secular bull
market. In my opinion, there is little danger that nominal rates will outpace
the increase in the rate of inflation until the Fed unwinds its balance sheet
like it did under Paul Volcker 30 years ago.
Likewise, an
increase in the value of the dollar against another currency likely indicates
that the central bank of the other country is lowering real interest rates
and diluting the purchasing power of that currency at a greater pace than the
Fed. It does not necessarily indicate that the supply of dollars is
contracting or that our currency's intrinsic value has increased.
There will
come a time when the Fed's pursuit of inflation causes a massive crisis of
confidence in our bond market and in our currency. A sudden and dramatic
spike in nominal rates would send real interest rates rising and cause
devastation in most markets, including gold. However, because the Fed's
likely answer to such a crisis would be to create more inflation, any
pullback in gold should be muted as compared to stocks, bonds, and other
commodities.
Peter Schiff is CEO of Euro Pacific Precious Metals. Having
spent years encouraging his brokerage clients to buy physical gold, he grew
concerned about the growing number of unscrupulous dealers that tried to
"up-sell" customers to rare or collectible coins with high markups. Peter Schiff's gold coin buying philosophy is to buy for the coin's metal value, not its
claimed "numismatic" value. He decided to open his own firm to
sell investment-grade bullion products at competitive prices. Euro Pacific
only sells reputable, well-known coins that trade on the open market, such as
American Gold Eagles, Canadian Maple Leafs, and Australian Kangaroos. To find out more, please visit www.europacmetals.com or call us at (888) GOLD-160.
Peter D. Schiff
President/Chief Global Strategist
Euro Pacific Capital, Inc.
20271 Acacia Street, #200 Newport Beach,
CA 92660
Toll-free: 888-377-3722 / Direct:
203-972-9300 Fax: 949-863-7100
www.europac.net
pschiff@europac.net
Peter Schiff is
president of Euro Pacific Capital and host of The Peter Schiff Show.
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