• Login
• Register
• Subscribe

Gold Bull-ion?

Over the past decade, the price of an ounce of gold has soared, reaching a nominal (not inflation-adjusted) historical high of $1917.90 in August.  Although the spot price of gold declined to $1713/oz by November, this still translated into a 19.6 percent annual gain over that time span, compared to only a 16.73 percent total gain over the same time for the S&P 500 Index[i].  Considered to be a hedge against high inflation and financial crises, gold achieved high returns throughout most of the past decade without the prevalence of either scenario occurring until 2008.  Without any earnings, gold has no intrinsic value which makes even the cause of the price appreciation a source of debate.  While there are differing views as to why the price of gold has risen, the increase in price has caused gold to maintain its traditional allure.

Low Real Interest Rates

Unlike stocks, gold, and other commodities, produces no cash flow.  When the fixed return on bonds – especially US government bonds – is high relative to inflation, then gold becomes unattractive due to high real interest rates.  In contrast, when the fixed return in bonds is low relative to inflation, then there is a lower opportunity cost for holding gold.  In today’s low interest rate environment, the latter situation has occurred.  With the 10-year Treasury yielding less than 2.05 percent and the Consumer Price Index up 3.5 percent over the past 12 months, this amounts to a negative real interest rate of 1.45 percent[ii].  With the real rate of return on many short and medium-term bonds low or negative, there is little opportunity cost for holding a non-yielding asset.  Historically, low real interest rates bode we                                                                                                      ll for the price of commodities.  Following the collapse of the Bretton Woods monetary system in the late 1960s and early 1970s, the US experienced a period of economic stagflation – low economic growth with a high rate of inflation.  In this environment, real interest rates were sharply negative. As a result the price of gold soared to $850/ounce; adjusted for inflation this was equivalent

[iii]

to $2079/ounce at 2006 prices[iv].  In order to combat inflation running in the double digits, Federal Reserve Chairman Paul Volcker raised short term interest rates to over 18 percent, simultaneously causing real interest rates to surge.  In a matter of months, gold prices declined by 50 percent and eventually settled in the $300-$400/oz range.  More recently, the Federal Reserve maintained a relatively low federal funds rate – the overnight loan rate between US banks.  In turn real interest rates declined, and the price of gold increased.  In the fall of 2008, turmoil in the financial sector, including the collapse of Lehman Brothers, caused the Fed to cut short term rates to close to 0.  At the same time, inflation decelerated significantly and shortly turned negative.  Therefore, real interest rates briefly rose, and the price of gold actually decreased during the last 6 months of 2008.  With GDP growth picking up again in 2009, inflation – and inflation expectations – increased causing real interest rates to return to negative territory.  Concomitantly, gold prices increased dramatically throughout 2010 and 2011.

Central Bank Actions

At the beginning of 2008, the Federal Reserve’s balance sheet was comprised of approximately $800 billion of securities (mostly all of them were Treasuries).  By July of 2011, its balance sheet had increased to over $2.8 trillion[v]! The additions – Treasuries, mortgage-backed securities, and Federal agency backed securities (Fannie Mae and Freddie Mac) - to its balance sheet were almost all in hopes of stabilizing asset price declines and pushing investors into riskier assets, such as stocks.  In order to increase its holdings, the Federal Reserve had to pay for the securities with money that banks hold in reserve at the Fed.  Therefore, the securities purchases increased the country’s money supply.  One of the unintended consequences of these actions was a rise in the price of gold.  A recent study by the World Gold Council discovered that historically when the Federal Reserve increased the money supply by 1 percent, gold prices increased by .94 percent. 

[vi]

At the same time the central banks of many other countries chose to ease their monetary policies as a response to the global economic slowdown.  Although their changes to the money supply did not have as high of a percent of correlation to gold prices as the US Fed, the correlations were still positive as both their money supplies and gold prices increased.  In the past two years, central banks have also increased their physical gold holdings: in 2010 central banks were net gold purchasers for the first time in two decades, and in the first half of 2011 central banks bought about 208 metric tons of gold, which is on pace to shatter the record of 276 metric tons bought by central banks in 1981[vii].  Yet, 1981 was also the start of a two-decade long bear market for gold.  What could make this time different?

[viii]

This Bloomberg “Chart of the Day” shows the proportion of gold held by different central banks as a percent of their total reserves.  While the US and Germany both hold over 70 percent of their total reserves as gold, the percent for China and Russia is just 1.6 percent and 8.2 percent, respectively.  Instead of gold, approximately two-thirds of their reserves are in dollar-denominated securities[ix].   Over the past decade, the value of these securities has declined because of the weak performance of the dollar.  Weighed against a basket of other currencies, the dollar hit a 40-year low in May[x].  In order to improve their diversification and hedge themselves against any future dollar weakness, the central banks of many developing nations have begun to increase their purchases of other assets, including gold.  For example, South Korea has the world’s seventh largest foreign-exchange reserve, and 64 percent of its reserves are in US dollars. Over the summer, South Korea’s central bank bought 25 metric tons ($1.24 billion) of gold – a 17 fold increase in their gold reserves[xi].  According to the International Monetary Fund, Thailand, Bolivia and Tajikistan also raised gold reserves in August, while the People’s Bank of China reported a third quarter increase of $4.2 billion. Therefore, over the past three decades the world’s central banks that have the reserves, and thus the ability, to buy gold have changed.  In 1980 the US was the largest creditor nation, while India, China and Brazil were large debtor nations.  China did not have any currency reserves in 1980, compared to $3.2 trillion in foreign reserves now (as of the end of the third quarter).  Because of their large holdings of dollar-denominated securities, a rebalancing away from dollars and into other assets – as has been the case over the past two years – could provide support for the price of gold.

Outlook for Gold

Starting at the beginning of July, gold rose from $1400/ox to over 1900/oz in a matter of 6 weeks as fears over the US debt situation drove people out of stocks and into, ironically, US government bonds and gold.  Subsequently, gold dropped to almost $1550/oz as fears of a global slowdown caused price declines in mainly all asset classes besides US government bonds.  Finally, the risk-on mentality returned in October: the S&P 500’s climb was its best monthly performance since December 1991.  Historically gold has had a slightly negative correlation with the stock market: gold increases are accompanied by stock declines and vice versa.  Yet, for the most part since 2006, gold and the S&P 500 have been positively correlated.

[xii]

The Fed has already announced that it intends to keep rates exceptionally low until the middle of 2013.  With the Fed intent on buying Treasuries with longer maturities, this may keep Treasury rates low for the next couple of years.  Over the past month US economic data, including consumer spending, housing prices, and GDP, have been steadily showing signs of improvement.  Economic growth of above 2.5-3 percent has historically been accompanied by moderate inflation (3-5 percent).  Consequently, real interest rates may continue to be low or negative – historically times of outperformance for gold.  Moreover, foreign central banks may continue to diversify their assets by buying non-dollar denominated securities.  If the last two years are any indication of their buying power, this could be a bullish sign for gold.  Finally, the US Federal Reserve, the European Central Bank, the Bank of Japan, the Central Bank of Brazil, and the Bank of England have all recently announced plans to maintain or expand their policies of monetary easing.  This has usually been good for gold, and we think this may be the case again. 

In the short term – less than 6 months - a drop in the price of gold below $1475/ounce could provide a good buying opportunity – for both individual investors and central banks.  Also, if gold rose above $2000/ounce, then that could be a signal for investors to sell their gold holdings.  Over the long term, the outlook for gold appears murky.  Historically, rising stock prices have occurred in tandem with a strengthening dollar and thus a decline in the price of gold.  The uncertain outlook for US monetary and fiscal policy over the next 5-10 years leaves a long term view on gold foggy as well. 

Article Archives : 2012 and 2011