The Moral and Prudential Algebra of Gold in 2011


 

 
     
 

We were pleased with our estimate for gold in 2010, having predicted gold between $900 and $1,200 with the potential to reach $1,500 should some catalyst present itself.  On average gold traded over the high end of this range, but stalled there due to a sluggish economic recovery and a strong dollar.  But late in the year, with Fed Chairman Ben Bernanke pursuing deflation like Moby Dick, wielding a second quantitative easing program of $600 billion to harpoon falling prices, gold scaled up short of our upside outlier estimate.  Since the beginning of 2011, gold has corrected to the pleasure of sharp traders, while we maintain a longer view for higher gold prices beyond the near term.

Investment demand for gold may have pushed aside increased seasonal demand by gold fabricators in the fall of 2010.  Rather than waiting for gold prices to correct in the spring due to changes in seasonal supply and demand, it would appear metal prices faded in the first week of 2011 due to investor year-end rebalancing, profit taking, and possibly, computerized trading. These non-fundamental influences may have added to the metal’s volatility, and even more so for that of mining and metal stocks.  Even with this correction, we stand behind our recent estimate for 2011, of gold trading between $1,300 and $1,500 with potential to see $1,600 by the end of the year.  As in 2010, we remain bullish on gold for 2011 (well above cost of production for many gold producers; essential for keeping mining stocks interesting) and are again comfortable with not offering an outlier at a lower price.

Gold is a Constant, a Useful Measure of Value, and a Mirror of Societal Progress

The basis for our outlook is aligned with Friedrich von Hayek’s The Use of Knowledge in Society, which recognizes that markets are both perplexing and dynamic, and so maintain a bias toward “day to day knowledge,” over scientific knowledge that may be useful only for contrived econometric modeling.  We have more confidence offering an opinion beyond the near term, taking into account the general factors that from time to time have shown to be reflected in the gold price. This process is not unlike how the early scientist and philosopher Benjamin Franklin developed and tested a hypothesis. Franklin utilized a Moral or Prudential Algebra, listing the arguments for and against, and by identifying offsetting factors and a process of elimination, produced a reasoned position to test.

Gold is useful as a constant in a relative world and a measure of investor’s expectations relative to other assets.  It is said that all the gold mined would fill two Olympic-size swimming pools or equal one third the size of the Washington Monument. While gold continues to be mined, production is not excessive, and relative to industrial and other uses, the supply is reasonably constant with the price moving up and down in relation to demand. The demand for gold may move lower as supply of competing assets decline, becoming rarer, and/or the relative demand for these other assets increases. Likewise, the demand of gold may move higher as the supply of competing assets increase and/or the relative demand for these assets decline.  As world finance moved away from gold as money as a medium of exchange, and the important attribute of money (currency) as a store of value has since weakened, the price of gold may be the best unbiased indicator of the relative strength of global currencies, non-tangible assets, and the character of nations in general.

Pertinent Factors Influencing Demand for Gold Beyond the Near Term

Higher demand for gold would be paramount in its use as a store of value for feared worst case cataclysms. In an apocalypse, holding physical gold may not be enough. This brings to mind the old Far Side cartoon of two curmudgeons fishing, with a mushroom cloud billowing in the background, reasoning that “this means size doesn’t matter and screw the limit!”  In a more practical setting, ownership of gold is seen as the best hedge against uncertainty, financial and otherwise. This article, admittedly from a U.S. perspective, hopes to identify economic trends, which, influenced by U.S. fiscal and monetary policies, may have a significant influence on the average price and trend for gold in 2011. As the U.S. dollar is the world’s reserve currency, this article may be of use from a global perspective.

Gold bears may be looking for gold to decline in demand relative to increased demand for dollar-denominated non-tangible assets such as stocks, bonds and even currencies.  This would suggest that the assets underlying those dollar-denominated investment instruments would be increasing in value. Fundamentally, this would imply that these instruments would represent assets with increased market share, expanding margins, profitability and purchasing power. Increased demand for these assets may also result from the expected cash flows produced by these assets being discounted, potentially at stable or lower rates. Discount rates incorporate both specific and general risk, including the risk of inflation of the currency for which these cash flows are denominated. Clearly, investors demand a real return on their investment.

The argument against gold seems to view gold as one asset class among many, as opposed to an asset against which all other dollar-denominated assets may be measured. This point of view makes it difficult to see past the illusion of nominal value, as opposed to where all other dollar-denominated intangible asset classes are actually declining relative to gold. This perspective can eventually lead to observing gold as in some form of “bubble.” We do not see gold in this light.


Source: Laffer Associates

We are intrigued by the movement of gold prices. Our interest over a decade ago was based on the predictive ability of gold movements foretelling the direction of interest rates. Gold has been seen as a hedge against inflation, and interest rates can be understood to encapsulate some form of inflation. With the low interest and inflation rates over the last ten years, based upon earlier conventional wisdom, one might not have expected gold to have risen to current levels. 

It may be useful to pull out old analyst reports and economic studies with their backward looking metal price assumptions to see how far we have come. For both inflation and interest rates, at least as we understand them today, we are clearly in new territory. It is interesting to ponder why the price of gold has decoupled from inflation and interest rates.  It may be that these alternative monetary measures may not be calculated using an appropriately consistent “basket of goods” or have been potentially managed by monetary policy leaders.

We again suspect that the rise of gold prices reflects the increased supply and declining demand for competitive assets. Our primary focus is for sustained expectations of an increasing money supply, which, in our opinion, may include both the monetary base and debt. If the level of gold may be assumed constant, the same cannot be said for the monetary base or the federal debt, both of which have increased over the last decade, and even more so since the financial crisis. This may be exacerbated in the coming year with an economic recovery increasing the leverage of the monetary base and velocity of currency in circulation as lending increases.  In addition, with deficits as far as the eye can see, federal debt should increase even with exceptional increases in tax revenues, and even more so should interest rates move higher. This perspective anchors our perspective for gold prices in 2011.

M Debt and Deficit
Source: Federal Reserve Bank of St. Louis

The Case for Higher Gold Prices in 2011

The Federal Reserve was originally established in order to transfer the responsibility for avoiding financial panics from one individual, J.P. Morgan in this case, to the people, or the U.S. government through a national banking system. That was a time in U.S. history when the government was weak and banks were strong, as opposed to the current era where government is strong and banks are weak. The recent excesses, at a minimum including loose monetary policy, fraudulent loan originations, and excessive leverage, led to the financial panic of 2008 – just over one hundred years since J.P. Morgan stepped in during the Panic of 1907.

O Excess Money Supply and Inflation
Source: Laffer Associates

Fed Chairman Ben Bernanke, seeing a seizing up of credit markets, was quick to respond by expanding liquidity by expanding the monetary base. This response was similar to successful Fed actions during the Asian Contagion in 1998 or in anticipation of Y2K. It was significantly different due to both the size of the action and its duration.  By definition, this suggests that the current financial situation may be increasingly viewed by monetary policy makers, not as a temporary “crisis” or “panic,” but a sustained downturn of prices and economic activity, with the risk of deflation morphing from recession to depression.

O Monetary Base
Source: Laffer Associates

The immense increase in the monetary base would have led to inflation, if not for the seizure of capital markets, followed by deleveraging and subsequent reduction of economic activity.  We again look to Irving Fisher’s Equation of Exchange which may provide some helpful insights. The Equation of Exchange is M times V equals P times Q (MV=PQ), where M represents the current monetary base and V represents velocity, or the rate at which money circulates through the economy.  The product of M and V quite simply must equal Q, or economic output, which is the sum of all goods and services transacted in the economy adjusted for the price of money, denoted by the letter P. 

M Velocity
Source: Federal Reserve Bank of St. Louis

The increase in the monetary base appears to have roughly offset the decline in velocity, though we may have experienced a brief period of deflation. It would also appear that the monetary base substituted for leverage provided in the banking system as seen by the retraction of the M1 Money Multiplier. Quite possibly, while liquidity was made available for banks identified as Too Big To Fail, credit and cash contracted for those smaller banks and commercial enterprises lacking deep pockets and a political lobby.

Following the Money Equation, the increased monetary base offset the decline in velocity, but was insufficient to offset a broad decline in economic output leading to a temporary period of deflation. The increased and sustained monetary base may have led to financial misallocations or distortions. We would argue both the cause, and the cure, for the most recent financial crisis is reflected in the paradoxical increase in the gold price and unemployment; with low inflation and nominal short-term interest rates.

N Money Multiplier
Source: Federal Reserve Bank of St. Louis

The increasing money supply on the left side of the Money Equation should balance with the increase in economic output and/or prices on the right side. To the casual observer, it would appear that the economy has moved beyond the risk of deflation. If this is the case, a sustained monetary base with increasing velocity may be inflationary if not accompanied by economic growth. This is the classic situation where there may be “too much money chasing too few goods” and paradoxically we see excess liquidity without a commensurate increase in economic activity. This is also referred to as a Liquidity Trap.

M MZM
Source: Federal Reserve Bank of St. Louis

The product of an increased monetary base and declining velocity was insufficient for keeping the money supply from contracting from 2008 through 2010.  While the economy appears to have bounced off the bottom, Fed Chair Bernanke remains quite concerned about the high level of unemployment, especially as it may include a greater number of the long-term unemployed.  In recent comments, he remains unconcerned about inflation, and having previously listed his ongoing aversion for deflation, he is proceeding unimpeded with an additional $600 billion stimulus program.

No Direction Home: What to do about unemployment?

Setting aside the Money Equation for the moment, Fed Chairman Ben Bernanke, while subject to the laws of nature, is also subject to the law of the land. The Federal Reserve is governed by the Full Employment and Balanced Growth Act, also referred to as the Humphrey-Hawkins Full Employment Act. The law presumes the relationship exhibited by the Phillips curve that there is an inverse relationship between unemployment (slow growth) and inflation (high growth).  Since Fed Chairman Ben Bernanke has recently stated that he has a “100%” level of confidence that inflation can be contained by available monetary tools, for his purposes, any increase in the money supply should translate into an increase in economic growth.  In other words, don’t worry, be happy.

L Unemployment and Duration
Source: Federal Reserve Bank of St. Louis

It is difficult to imagine the economy growing while the labor force is declining in the aggregate or the labor force is declining as a percentage of the GDP.  More alarming is the increasing level of unemployed for longer durations. Fed Chair Ben Bernanke is rightly worried.  He stated, “The aspect of the unemployment rate that really concerns me is that more than 40% of the unemployed have been unemployed for six months or more, and that’s unusually high. And people who are unemployed for such a long time – their skills erode, their attachment to the labor force diminishes, and it may be a very, very long time before they find themselves back in normal working position.”  While payrolls increased about 103,000 in December, 2010, this was less than the 200,000 needed for sustaining growth. Worse yet, the decline in the unemployment rate was attributed not to the increase in payrolls, but to the 260,000 unemployed believed to be giving up seeking employment and no longer counted in the unemployment rate.

N Average Duration of Unemployment
Source: Federal Reserve Bank of St. Louis/Bureau of Labor Statistics (seasonally adjusted)

The increase in duration of the unemployed, those seeking employment, is leading the nation into uncharted territory. While concerns are raised regarding the independence of the Federal Reserve, presumably by those who may be concerned about loose monetary policies leading to inflation, the Humphrey-Hawkins Full Employment Act eliminates any true independence. The Act requires consideration of a number of economic issues that may lead to policies in opposition to monetary stability, which is an important characteristic of money as a medium of exchange and store of value.  In any event, Fed Chairman Ben Bernanke has a perspective grounded in the belief that the Depression was due to a tight monetary policy and he may personally hold an aversion to being left holding the bag should the economy double dip into a lengthy economic decline linked to deflation. From this perspective, the Fed Chairman is legally, academically and personally predisposed to carry out the purchase of $600 billion in Treasuries.

Gold Outlook for 2011: the glass half full

There seem to be hints of a new fiscal conservative wind blowing in the U.S. for federal, state and local government. The extension of the Bush tax cuts may only help head off a decline in the national economy, but even a change in the U.S. House of Representatives may be insufficient to reduce spending or regulations which may retard economic growth. This situation is likely to persist beyond 2011. According to the Money Equation, should the money supply increase faster than a growth in output, inflation should ensue. This suggests that a period of stagflation with both high unemployment and inflation is ahead.

L Interest Rates
Source: Federal Reserve Bank of St. Louis

To stimulate the economy, the Fed Chairman Ben Bernanke is well disposed to hold down short-term interest rates through open market policies. This helps banks to borrow short term on the cheap and realize higher margins to build capital, leading to a healthier banking system.  In addition, the loose monetary policy and low rates may buoy the real estate markets, helping banks with large real estate exposure move more solidly into the solvent category. Consequently, it is likely that loose monetary policies, combined with the other excesses such as leverage and fraudulent lending practices, led to a “bubble” in real estate values from 2005 to 2007.  With the collapse of leverage in 2007 and 2008, real estate values collapsed but gold continued to move higher. While the Fed Funds and 3-Month Treasury rates have been flat and near zero, 10-Year Treasury rates, along with 15 and 30-year mortgage rates are moving higher from record lows.

O Fed Funds and Commodity Index
Source: Laffer Associates

Near zero Fed Funds rates seem to explain the recent price increases in commodities such as gold.  This relationship appears consistent over the last decade and one may easily conclude that the extended periods of low interest rates may lead to higher commodity prices. Given our read on Fed Chairman Ben Bernanke, and calls for Federal Reserve independence during a political period still dominated by legislative proponents of additional stimulus programs, we don’t see a change of course in 2011. Gold bugs should be very wary if Fed Chairman Ben Bernanke acts upon his threat to increase interest rates (including foreign buyers of U.S. debt). Knowing that higher interest rates may derail an economic recovery, the question investors should concern themselves with, is will he (or does he have the nerve to) pull the trigger on higher interest rates?

Higher interest rates are important in a functioning economy for efficient capital markets to discipline borrowers and reward investors and savers. Our fear for the economy is that the longer interest rates are artificially suppressed, the greater the likelihood of inflation, and more painful the remedy. Higher interest rates were necessary to drive inflation out of the economy in the early1980s. Recently, the U.S. has enjoyed the best of both worlds – a strong dollar to the Euro, and a cheap source of products from Asia. The odds of this temporary happy state of being to change over the long run are very good.

The Moral and Prudential Algebra for Gold in 2011

It is reasonable to assume that the aggregate supply of gold should remain relatively constant in 2011. Having increased the monetary base, the Federal Reserve plans to continue its program of buying Treasuries to stimulate growth. With some improvement in consumer confidence and bank lending, the velocity of money is increasing. Combining the monetary base with the velocity of money, the money supply is likely to expand in 2011. The uncertainty of government regulations may retard economic growth for all but the largest of companies and, with an increasing level of long term unemployed, may place a drag on the economy. The level of government debt is likely to increase, absorbing cash stimulus by the Federal Reserve. The sum total of these proceedings should increase the total amount of dollar denominated assets, which could lead to even higher gold prices in 2011.

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