What's Going on in the Gold Market? Spring 2010

What's Going on in the Gold Market? Spring 2010

In our Shareholder Reports, we have been saying for a decade that the price of gold is inversely related to investor confidence in paper assets - fiat currencies, stocks and bonds. As confidence in these paper claims declines, the relative value of physical gold tends to rise. Essentially, there are two processes which undermine the perceived security and value of paper assets - debasement and default. Debasement is the effect of creating too many paper claims - the growing quantity undermines their quality - especially money and debt. Default is the repudiation of these claims by the issuer.

A cursory review of the headlines confirms that the risks of debasement and default are on the rise. Sovereign liabilities are being created at a feverish pitch throughout the developed world, to pay for economic stimulus as well as bailouts of the financial system, the housing market and major industrial firms, to finance vastly increased transfers to individuals to offset the impact of recession and borrowings to cover falling tax revenues. Unless the basic laws of economics can be repealed, the enormous increase in the quantity of sovereign liabilities must begin to erode their price, increase the risk of default and raise interest rates. For the moment, perceptions of heightened risk have focused on weaker credits on the periphery of the world's financial system such as Dubai and Greece. However, the larger developed economies are also at risk.

Société Générale recently put together an analysis of on-balance-sheet debt (already issued) and off-balance-sheet debt (that will be incurred to meet current commitments for social security, etc.) as a percentage of GDP. They confirm that the Greek government is not the only one to be technically insolvent. The U.S. and France have total obligations more than five times their GDP while Germany and the U.K. are at four times.

Thus far, investors have been relatively undisturbed by the facts, reminiscent of the early days of the subprime mortgage crisis. But a report issued in April 2010 by the Bank of International Settlements entitled "The Future of Public Debt" confronts this complacency directly: "The question is when markets will start putting pressure on governments, not if. When will investors start demanding a much higher compensation for holding large amounts of public debt? In some countries, unstable debt dynamics - in which higher debt levels lead to higher interest rates, which then lead to even higher debt levels - are already clearly on the horizon."

In earlier reports, we have called this debt issue the "funding crisis". The market seems to be placing it in the distant future, but for the U.S. it may be much sooner than most of us think. It is estimated that 44% of U.S. federal debt must be rolled over this year, in addition to new issuance. In total, the U.S. Treasury must finance in excess of US$3.5 trillion this fiscal year. This enormous issuance will apparently not be helped by quantitative easing, which the Federal Reserve stopped on March 31, 2010. We believe that last year's US$1.6 trillion in deficit financing probably could not have succeeded without US$1.75 trillion in liquidity added by the Federal Reserve's quantitative easing programs.

Despite the wider evidence, debt and currency markets have been focused on Greece and the euro has been the loser. For much of the past year, gold has traded with the euro and against the U.S. dollar. This relationship may have been weakened somewhat in recent weeks but the fact is that gold has faced strong headwinds in dollar terms, trading well below its December 2009 high even as it has set one record high after another in euros, yen and pounds. Optimism about the U.S. economy and market anticipation of Federal Reserve tightening, despite very clear communication from the Fed to the contrary, have also held the U.S. dollar gold price in check. Gold is not going to achieve its bull market potential, in our view, until it breaks to new highs against the dollar, which remains the world's dominant reserve and trading currency.

We believe that gold may not be very far from achieving new dollar highs. First, the U.S. economy is not outperforming its peers. As the current year unfolds, we believe the evidence will demonstrate that the U.S. economy is lagging much of the rest of the world as unemployment remains high, state and local governments encounter more budget difficulties and prime mortgage defaults accelerate, deepening the housing crisis. We do not see tightening by the Federal Reserve this year; in fact, we see a resumption of quantitative easing, with the most significant reason not high unemployment or Treasury financing needs, as important as they are, but rather private credit contraction.

The private sector is deleveraging. To offset this development, the public sector is leveraging up and the Federal Reserve is increasing its balance sheet. With contractions in bank credit, very slow to negative growth in the popular measures of money supply and very low levels of consumer price inflation as currently reported by government, we see lots of incentive for the Federal Reserve to increase system liquidity while the Treasury may well be forced into further spending to support the economy.

The year-over-year change in U.S. private sector credit outstanding is in negative territory for the first time in nearly 60 years of Federal Reserve data. This credit contraction is accelerating, based upon fourth quarter 2009 data. M2 money supply growth (a measure we think is flawed but which the Federal Reserve says it relies on) is near the lowest level in 15 years. Despite a tripling of the Federal Reserve balance sheet to more than US$2.3 trillion since 2008, year-over-year M2 is up only US$40 billion. Given these facts, we believe it is most unlikely that there will be any moves by the Federal Reserve or the Treasury to reduce liquidity or impose real austerity on public sector spending, both of which would probably strengthen the dollar. Debasement is the clear direction of public policy. In our view, a new U.S. dollar record high for gold can be expected this year, with the possibility of much higher prices as the sovereign debt crisis unfolds and comes closer to home.

Excerpt from the Report to Shareholders, April 23, 2010

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