Gold - Renewed Upswing Underway

Gold’s recent price performance, strong physical demand for the metal in important world markets, worries about US public debt, continuing aggressive monetary stimulus by the US Federal Reserve, and news of substantial long positions by some prominent institutional investors and sovereign wealth funds, suggest that gold may soon resume its long-term upward march.

Indeed, I believe that after the past three-month period of correction and consolidation beginning in early December 2009 (when gold hit an all-time record price of $1,227 an ounce) gold will soon begin advancing anew – and could well register new US dollar-denominated highs by midyear.

Gold prices are already at record highs denominated in euros and British pounds, a reflection of declining confidence in those currencies and perceptions of rising sovereign risk on the debt of a number of European nations.

Meanwhile, the US dollar-denominated price gained about 1 per cent in February despite the dollar’s sizable appreciation in world currency markets.

Importantly, this may be signalling a breakdown in the inverse lock-step correlation between gold and the dollar that has characterised these markets in the past few years – and could be paving the way for gold to begin moving higher again even if the dollar continues to gain against other key currencies.

And, from a technical point of view, it is encouraging that gold managed to hold up early this year despite several tests of the $1,100 price level, easily bouncing back each time to slightly higher price levels. This has encouraged some short-term speculators to adopt a more positive view of the market – and selling by institutional traders, which triggered and fed the metal’s decline late last year and early this year, is now diminishing.

European investment demand for physical gold has picked up in the past month – despite the record high euro-denominated prices. Some Europeans, with declining faith in the future value of the euro and a reluctance to continue looking at the dollar as a safe haven, are now turning to gold as the ultimate safe haven.

India, historically the biggest gold-consuming marker, has seen a big jump in gold investment – and imports – in January and February. A few weeks ago, we reported Indian gold imports in January of sixty tons, more or less. Now, we hear that February’s imports will again be quite strong. The estimate by the Bombay Bullion Association of 30 to 35 tons are likely to be on the low side (as they often are) – and actual imports could again be close to January’s sixty tonnes.

Anecdotal evidence suggests that gold investment demand in China is also rising. Thailand, Vietnam, Taiwan, and other East Asian gold-consuming markets (where gold is a traditional savings vehicle as it is in China) are also seeing rising interest. China’s robust economic recovery and growth in household income is leading to more investment demand (as well as jewellery purchases). At the same time, rising agricultural prices are encouraging some additional “inflation-hedge” demand for gold.

Moreover, news a few weeks ago that China’s sovereign wealth fund, the China Investment Corporation, had recently purchased a few tons of gold, is surely viewed as an official endorsement of gold investment by China’s monetary authorities.

There has also been greatly reduced scrap supply from the recycling of old jewelry and investment bars in the region extending from the Arabian Gulf states (Saudi Arabia, Abu Dhabi, Dubai, etc.) across to India and Southeast Asia up to China. This certainly reflects the more positive outlook for gold held by investors in these countries but it also reflects improving economic circumstances and reduced “distress” selling by some.

Despite the recent hike in the Federal Reserve discount rate (the rate at which the Fed loans reserves to banks), the US central bank is maintaining a very aggressive – and, in our view, ultimately inflationary monetary policy. At last week’s Congressional testimony, Fed Chairman Ben Bernanke stressed yet again the central bank’s intention to maintain low rates for an extended period.

Another monetary indicator, the Monetary Base (currency in circulation plus bank reserves) surged by some $90 billion in the two weeks ending February 24th. This represents an annualised rate of growth of nearly 200 per cent – and tells me that the Fed is pushing liquidity into the economy just as hard and fast as it can.

In the long run, the dollar’s purchasing power – and consumer-price inflation – is a reflection of the quantity of money in circulation. The Fed keeps telling us that inflation is not a problem because of the high degree of slack (unused productive resources) throughout the economy.

But, even in the absence of robust economic activity and low rates of capacity utilisation, it is quite possible to have high rates of inflation. We need only look back to the 1970s, a decade of stagflation in the United States, for evidence that excessive monetary creation leads to excessive price inflation even when economic activity remains anaemic.

As in the 1970s, foreign central banks and institutional investors – who are the main holders and buyers of US Treasury debt – are now appearing increasingly reluctant to roll over existing positions let alone continue building ever-larger portfolios of US Treasury short-term bills, medium-term notes, and long-term bonds. Indeed, the Treasury’s last auction was greatly under subscribed.

This suggests that the Treasury will soon be forced to pay higher interest rates – to compensate buyers for the increasing risk they attach to US government paper – or turn to the Federal Reserve as the buyer of last resort.

In other words, rather than borrowing to finance our national debt the Fed will be forced to “monetise” a growing portion of America’s annual deficits by simply creating new money. This is essentially the same as “quantitative easing” – the purchase of government, agency, mortgage, or other debt by the Fed – to stimulate economic growth – only rather than stimulate the economy the end result will likely be the debasement of our currency and an acceleration in inflation.

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