FYI | Mar 20 2009
FNArena has received a question from one of our subscribers which we think is likely to be representative for questions among many more of our readers. Hence why Greg Peel has taken the effort to write a public response.
Question: everyone is reporting the price of gold is up but that only seems to apply when you look at the price in USD. If one bought exposure to gold in AUD, like me, the result thus far is actually a loss, not a gain. So what’s happening and what should I do?
Answer:
Mary I’m guessing you may have put on your GOLD trade around a week or so ago. If that is the case, US dollar gold has rallied around US$50 from US$900 to US$950 while Aussie dollar gold has fallen from around A$1400 to A$1350 which is A$50. The exchange rate between the two currencies over that period has risen from US$0.63 to US$0.68.
Such movements can thus be considered purely currency based. If gold is measured in US dollars, and the Aussie is measured in US dollars, then as the US dollar falls both USD gold and the AUD exchange rate should rise – which they have – and thus AUD gold must fall. If the US and Australia were the only two countries on earth, and gold the reserve currency, then such movements as have been seen over the last week would be the norm.
But it’s not as simple as that. Let’s zoom out the graph to one month.
Over the course of a month, AUD gold has fallen from A$1500 to A$1350, and the exchange rate has risen from about US$0.64 to US$0.68, but USD gold has also fallen – from US$1000 to US$950.
What’s going on here? How can gold fall against both currencies when the exchange rate movement suggests USD gold should rise?
The answer is that speculators took over gold in February. Speculators pushed gold to the magic US$1000 mark on a frenzy of sentiment which proved greater than exchange rate movements. Having rung the bell, the profit-takers moved in and sent gold scurrying again. As the US stock market began to rally, some punters decided they did not need their hedge against risk anymore.
Gold rose to US$1000 even as the US dollar index (against major currencies) was also rising. So now we have gold which is measured as the inverse of one’s own currency, and gold which plays the role of a “safe haven” against general global risk.
Now let’s zoom out that graph again and go back to November 2008.
At the beginning of November the AUD exchange rate was about where it is now. Indeed the US dollar index was also about the same. Yet over that period, USD gold has rallied from around US$800 to around US$950 while AUD gold has rallied from A$950 to A$1350. If there have been no relative currency movements, why has gold rallied?
The answer is because over that period, all major trading nations have been throwing all manner of stimulus packages at their economies in a globally concerted effort. These include fiscal stimuli (cash hand-outs) and monetary stimuli (cutting interest rates). Take the UK as an example. It has provided fiscal stimulus, all but nationalised half its banking system, and the Bank of England has begun buying UK bonds. The UK has no money – it is merely printing it.
The world has followed a similar path but some have started from a better position than others. The UK had a fiscal deficit to begin with and so any stimulus is just getting the UK further and further into debt. Australia started with a surplus so while we will now go into a deficit we are not simply adding debt on debt.
The UK took the unusual step of buying its own bonds. To fund such stimuli, a country must issue bonds which is simply a way of asking others to lend the government the money. But when there was not enough money being lent, the Bank of England stepped in to buy the bonds in order to fund the money the government was printing. Where did the BoE get the money? From the government printing more money.
The same policy has been taken up, over the period, by Japan, Switzerland and Sweden. It means that these countries are all “debasing” their currencies. This is very inflationary. And when inflation runs rampant, the “inflation hedge” or the “store of wealth” is gold. Therefore, if you consider gold as the counter to ALL paper currencies, and not just the US dollar, then you can see why the value of gold can rise against ALL currencies simultaneously irrespective of individual exchange rate movements.
Call it the bigger picture.
While the rest of the world had been taking these unusual steps of “quantitative easing”, the US had not. But this week it has. And as a result, it is now the US dollar which has dropped substantially.
Now zoom the graph right back in again. Over the week, as noted, the US dollar has fallen, Aussie has risen, and therefore USD gold has risen and AUD gold has fallen. These have been sudden and sharp movements on a very short term scale, or in the smaller picture. Yet as I have shown, take a few steps back into the bigger picture and one can see the reason why anyone might suggest you buy gold – in any currency. And the reason is global inflation.
If global inflation strikes, then gold can “decouple” from any specific currency exchange rate and simply rally against the collective paper (fiat) currencies of the world. So thus the six million dollar question is: Will global inflation strike?
The reason why governments and central banks across the globe feel safe in printing so much paper money to throw at their economies is because we are currently suffering from disinflation. As the great credit bubble is being rapidly deflated and asset prices – for houses, office blocks, cars, mines, shares, commodities – are falling there is a very real risk the global economy could fall into deflation, meaning prices for everything (and wages) just keep trending down (as happened in the Great Depression). If the global economy falls into deflation, then massive amounts of printing can’t hurt, in theory, because the inflation created by printing money simply offsets the deflationary force of falling prices and unwinding credit. Get it right, and the global economy should be able to return to a neutral level of low and healthy inflation.
But if the deflationary forces are too strong – and bear in mind the first world has created the greatest credit bubble known to mankind and that has to be unwound – then in order to stave off another Great Depression governments will just have to keep printing and printing and printing and printing. No one will have any money to buy bonds, so central banks will have to keep buying bonds which they fund from even more printing.
At some point all that printing must win. The global economy should stabilise given the amount of free money around. But if it stabilises, what happens then? What will have happened is that monumental credit bubble – all that global debt – will have been replaced with paper money. If everyone has lots of paper money and the economy only slowly begins to turn around then the rush will be on the see who can offer the most pieces of paper to buy oil, to buy shares, to buy a loaf of bread. This is called hyperinflation.
That’s what is happening in Zimbabwe.
If the world suffers from hyperinflation, the gold price will go to the moon in every currency. Paper money will need to be spent immediately before inflation erodes its value, but at any point gold can be converted into whatever value of paper money exists on the day. In other words, gold is a store of wealth.
The market panicked this week when the US Federal Reserve announced it would start buying US bonds. The word “hyperinflation” was writ large. But as the US was only catching up to many of the other major trading nations, it was an isolated incident. Hence the US dollar fell, the Aussie rose, and Aussie gold thus fell when US dollar gold rose. The US dollar may yet fall further and the Aussie rise, meaning Aussie gold can fall further.
But take a step back, and Aussie gold has the potential to take off again. It will not take off if deflation is winning, it will likely drift off somewhat. But deflation can become inflation in a heartbeat if the governments and the central banks of the world over play their hands.
That is why many a respected economist is suggesting the world must take its medicine. If that means Great Depression II then so be it. For all the money printing is only putting off the necessary disaster – the necessary unwinding of first world profligacy – to another day.
Such commentators would tell you to hold on to your gold, Mary. Put it in a bottom draw and forget it’s there. Be prepared to ride out shorter term fluctuations in Aussie dollar value. Pull it out only on a rainy day.
(To all subscribers: FNArena has published several insightful stories and analyses on gold. To read up on the subject we invite you to have a look at the Sell&Buy-ology section on the website. Alternatively, put “gold” in the search facility to scroll through our archive of stories.)
