Commodities | Nov 07 2007
By Greg Peel
“Mervyn King’s effective guarantee of the liabilities of the British banking system is much more significant than declining South African gold production.” John Hathaway, Tocqueville Gold Fund (New York)
This particular comment goes a long way to explaining why gold is currently trading at nearly US$825/oz – a 28-year high. Mervyn King is the governor of the Bank Of England, and the comment refers back to the Northern Rock crisis when, under instruction from the Chancellor of the Exchequer, and against his previous judgement, King guaranteed all bank deposits in all banks in the United Kingdom. It was the height of the credit crunch.
There are a number of influences affecting the price of gold. Firstly, it has to be remembered that 70-80% of gold production ends up as jewellery, particularly around the necks, arms and fingers of Indian brides, Chinese entrepreneurs, Middle Eastern oil sheiks and the odd Fifth Avenue socialite. While gold is desirable simply for its beauty and status it is, in this sense, a commodity. The amount of gold used for actual industrial purposes is negligible.
The rest ends up as coins and bars, and in this sense (apart from the collector value of coins) gold is a currency. Of course, if you were short of currency you could always melt down (or hock) your jewellery. Gold is the only “true” currency as a store of wealth, because fiat currencies such as the US dollar are simply government IOUs. Silver, and to some extent the platinum group metals, are also “precious” enough to have currency value. By the time you get to copper there’s just too much of it about.
One reason the gold price is much higher now than it was at the turn of the century is because global production is on the decline, and jewellery demand, particularly out of Asia, has increased. Another reason is that global inflation fears have been spurred by the rise in the price of oil and other commodities. While fiat currencies are devalued by inflation, gold is not. Another reason is that it is a lot easier to invest in gold these days through various listed funds, rather than having to buy actual metal.
The last time gold was at the level it is now was in the late 1970s – the last time the oil price ran amok. Back then, inflation was well into the double digits. But this time global inflation, while creeping up, is much, much lower. Here we are worrying about 3% when 20% inflation was the story of the ’70s. Inflation is much lower through a combination of technology advances, which make everything from phones to televisions continuously cheaper, to the China phenomenon, which has meant significantly lower production costs.
So if inflation is comparatively negligible, why are we about to see a new high in gold?
The simple answer is that the real value of the US dollar has fallen a long way, and gold is denominated in US dollars. The dollar has declined all 2007, and initially it was all to do with the burgeoning US current account deficit and America’s thirst for spending and lack of savings. Basically that IOU had a lot of someone else’s debt behind it. But oil, grains, metals and bulk commodities are all denominated in US dollars, meaning that perceived inflation is really a closed-loop equation. Dollar goes down, oil goes up, that’s inflationary, thus dollar goes down, oil goes up…
The problem is the “other” inflation. Nobel prize winner Milton Friedman once famously said “Inflation is always and everywhere a monetary phenomenon”. While economists today all drink a toast to old Milt, his theories have long ago been relegated to historical curiosity. What Friedman was on about is that the only thing affecting inflation is the supply of fiat currency – the money supply – which is the preserve of central banks and their printing presses.
Even celebrated author and writer of the Hitchhiker’s Guide series, Douglas Adams, paid homage to Friedman. In Book III of the five-book trilogy, a space ship lands on an unknown planet and a colony begins. Given lack of any specific fiat currency, the ship’s captain declares the colony’s currency to be the leaf – any old leaf. The monetary system works fine briefly, until the price of one packet of ship’s peanuts soon becomes “the equivalent of three deciduous forests”.
In other words, the more abundant the currency, the lower its value. The US Federal Reserve’s printing presses have rarely had a moment’s respite as enough dollars have been produced to offset US debt. But when the credit crunch hit, the Fed turned off the safety valves and the printers have been smoking ever since. The only way to unfreeze credit and save the global financial system has been to print US dollars – pump liquidity into the system and lower the cash target rate by 0.75% (with probably more to come). That is the current monetary policy, and the more abundant US dollars have become the more their value has diminished. This is the “other” inflation – this is what old Milton was on about.
Returning to our opening statement, the governor of the Bank of England has guaranteed all bank deposits. The only way to do that in this environment is to print pounds. On that basis gold is not just responding to the US dollar, it is responding to the collective diminishment in value of all fiat currencies. The US is not alone.
And it doesn’t matter that if the US has a massive current account deficit it is offset by massive surpluses elsewhere in the world. Last month equity analysts at Credit Suisse noted “there is a danger of devaluation [of the dollar] because of the behaviour of the emerging market central banks”.
“China is a good case in point. To keep the yuan pegged at an undervalued level relative to the US dollar, Chinese authorities need to expand their money supply aggressively. This is the same as adding US dollar liquidity to the global financial system, effectively devaluing the US dollar relative to real assets such as gold and base metals.”
Credit Suisse notes that world economic growth is surely driving commodity prices, but just as important are liquidity and relative scarcity. [The unbelievable price rise in our ship’s peanuts lent much to the demand for peanuts, but much more to the excessive abundance of leaves]. Continued US dollar monetary supply expansion [more leaves], says Credit Suisse, will continue to devalue the US dollar [leaf] against gold, base metals, the euro and the Aussie dollar [peanuts].
The scary part is that this whole situation is a bubble that must surely burst, just as our colony must eventually reach a point where its forests are totally denuded. The burst will likely come from China, whose runaway economy simply can’t just keep running away. But that is a story for another day.
Let’s go back to the introductory comment as made by John Hathaway, portfolio manager of the US$1 billion Tocqueville Gold Fund in New York. John Dizard of the London Financial Times spoke to Hathaway this week.
The Tocqueville fund achieved a 38.2% return in the twelve months to September. But in that time, net purchases of fund shares totalled US$330m while withdrawals totalled US$280m. That’s only a net inflow of $50m. Said Hathaway: “If the public had really bought into this bull market story, then we would be looking at something better than annual net inflows of 5-6 per cent”.
What’s more, Hathaway points out that one month volatility for gold is currently about 20%, while back in 1980, when prices were last at these levels, it was 50-60%. As far as he is concerned, this is signal that the bull market hasn’t actually started yet.
“The relatively subdued interest of the investing public, if not the investment newsletters and columnists, is actually good news for those long the metal. It means there are a lot of people left to buy the stuff, which is not the case at bull market peaks.”
Dizard notes that in recent years gold has not risen nearly as much as, for example, nickel copper or lead. While the immediate demand coming out of emerging markets has been for consumables, so too have portfolio managers repositioned themselves as investors of commodities in order to keep the funds flowing in. Dizard suggests it’s time they reposition once more. It would be misleading to simply look at jewellery demand and mine supply, he believes. It’s all about currency.
But whether or not gold is on the move to ever greater heights, every investor still needs fiat money to buy bread and milk. If gold is rallying on a collapsing US dollar, but so too is the euro, the pound, the loony (Canada) and the Aussie, what good is gold investment unless you’re trying to buy bread and milk in Manhattan?
The answer is that with its most recent rush from US$700/oz through US$800/oz, gold is not just a US dollar story but a fiat currency story in general. This is what a chart of the US dollar looks like:
But this is what a chart of gold in euros looks like. Until this last spike, the rise in US dollar gold has not been able to add value to gold in euros, due to the falling US dollar:
But are we now looking at a breakthrough? Gold is starting to look good against the pound (where Mervyn King has guaranteed bank deposits):
It has always looked good against the yen, because the carry trade has kept downward prsessure on the yen against the US dollar (ie the dollar has not fallen as much against the yen):
The flipside of the carry trade has been a serially strong Aussie, much stronger than the simple fall in the US dollar suggests. Hence Aussie dollar gold has struggled to reach new heights:
And the story in equally commodity-rich Canada has been even worse:
(Source of non-US dollar charts: jsmineset.com)
So the question now is: will gold break up against every fiat currency, thus establishing itself as the “true” global currency? The flight to quality appears to have begun in earnest.
