What
really drives the price of gold? Some say it's a fear gauge. Others prefer to
look at the demand coming from the Indian wedding season. But the silliest of
all conclusions to reach is that the dollar price of gold should be
determined solely by its value vis-à-vis another fiat currency.
The
truth is the primary driver of gold is the intrinsic value of the dollar
itself, not its value on the Dollar Index (DXY). The intrinsic value of the
dollar can be determined by the level of real interest rates. Real interest
rates are calculated by subtracting the rate of inflation from a country's
"risk free" sovereign yield. Right now the level of real interest
rates in the U.S. is a negative 1.55%.
A key
factor is to then determine the future direction of real interest rates. The
more positive real rates become, the less incentivized investors are to hold
gold. And the opposite is also true. The more negative real rates become, the
more necessary it is to own an asset that is proven to keep pace with
inflation. The Fed has threatened to begin lift off from its zero interest
rate policy in the middle of next year. However, the Fed has made it clear
that it will only raise nominal yields if inflation is rising as well.
Therefore, there is no reason to believe real interest rates will rise
anytime in the near future.
The
intrinsic value of the dollar is not rising; and most likely will not
increase for the foreseeable future. The dollar is only rising against other
currencies because the value of those currencies are being pummeled by their
central banks to a greater extent than our Fed. The weightings in the DXY
favor the performance of the dollar against the euro and the yen. Therefore,
just because the nations of Europe and Japan are determined to completely
wreck their currencies does not mean that the intrinsic value of the dollar
is improving or that the dollar price of gold must go down. In fact, holders
of the euro and yen should be more compelled to own gold than ever before.
The
sophomoric view held on Wall Street is that gold must go down if the dollar
is rising on the Dollar Index. Their specious argument is that it's more
expensive to buy gold because of the dollar's strength, and therefore demand
for the commodity must decrease. However, this argument completely overlooks
the increased motivation to buy gold emanating from the continued attack on
the yen's intrinsic value by the bank of Japan. For example, real interest
rates in Japan are a negative 3% and are promised by the Bank of Japan to
keep falling. Japanese citizens should be scrambling to own gold in this
scenario even if it will take more yen to buy an ounce of gold. And from all
evidence available demand for the physical metal remains strong.
Supply
demand metrics for gold are currently favorable. Central bank demand
increased to 335 tons so far this year, up from 324 tons in 2013. Investment
demand is up 6% YOY, while supply was down 7% YOY in Q3. Nevertheless, gold
is down about $100 an ounce YOY, and gold mining shares have plummeted by
about 30% during the same time period. This is due to short selling of gold
futures by banks that wish to see the gold price lower. In the short-term
financial institutions may be able to manipulate gold prices lower, as they
bring to fruition their self-fulfilling prophesies.
However,
in the long run there exists three great risks to markets and the global
economy in general that will be very supportive for gold: A collapse of the
yen that becomes intractable; spiking interest rates in the United States due
to the Fed's unwillingness to get ahead of the inflation curve; or, more
likely, a significant weakening in U.S. economic data that puts serious doubt
in the sustainability of the recovery and corporate earnings growth.
At
least one of these events is guaranteed to occur because the free market
price discovery mechanism has become completely abrogated and has been
replaced by government manipulation of all asset prices. When these massive
bubbles break it won't be so easy to put them back together again because
central banks and sovereign balance sheets are already at a breaking point.
Therefore, the recovery won't be as easy to engineer like it was back in
2009.
Equity prices
have been propelled to record highs by the money-printing frenzy of central
banks. And the Fed Funds Rate is near zero percent, instead of a more normal
5%. The total debt in the United States is near an all-time record 320% of
GDP. U.S debt is up $7 trillion (14%) and global debt has increased over $30
trillion (40%) since 2008. Most importantly, the record amount of debt has
been coupled with interest rates that have been artificially manipulated to
record lows around the world for the past six years and counting.
This is
why I know it will all end very badly once interest rates normalize.
Regardless of bank manipulations and the BOJ's kamikaze mission to commit
Hara-kiri with its currency, gold will be an increasingly-necessary asset to
own. Especially after this current illusion of prosperity comes crashing
down.
