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It's a matter of confidence
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Below is an extract from a commentary posted
at www.speculative-investor.com on 13th January 2005.
Gold is not a hedge against
inflation (inflation, here, being defined as an increase in
the supply of money and credit). For example, there was rampant
inflation in the US during 1997-2000 and yet gold fared poorly.
On the other hand, there was rampant inflation during 2001-2004
and gold did well. The big question, therefore, is: why did
gold supposedly benefit from the inflation of 2001-2004 and
not from the inflation of 1997-2000?
The short answer is that the US$ was strong
during 1997-2000 and weak during 2001-2004, but this answer
just begets another question: why was the US$ strong during
the first period and weak during the second?
The reason is that confidence in the dollar
was rising during 1997-2000 and falling during 2001-2004.
And this trend reversal in confidence occurred because it
started to become clear, during the second half of 2000, that
the US economic boom was the result of credit expansion and
speculation rather than a "technology-driven productivity
miracle". The US therefore went from being widely perceived
as a country that offered superior REAL returns on investment
to one that offered relatively poor real returns on investment.
After that, the effects of inflation began to appear more
in the prices of gold and commodities and less in the senior
US stock indices.
The bottom line is that regardless of what is
happening on the inflation front, the investment demand for
gold increases when confidence in fiat currency -- in this
case, the US$ -- is falling. Inflation is often a cause of
such a loss of confidence, but situations sometimes arise
where higher inflation does not lead to a fall in confidence
and a consequential rise in the gold price. Furthermore, situations
can arise where confidence in a currency plummets, causing
the gold price to shoot upward in terms of that currency,
for reasons other than runaway inflation. The collapse of
the Argentine Peso following the removal of its US$ peg is
a good example.
This leads us to our main point, which is that
although confidence in the US$ has taken a hit over the past
three years the level of confidence in fiat currency in general
has not fallen to any meaningful extent. We say this because
the gold price in terms of major currencies other than the
US$ has moved sideways over the past three years. To be more
accurate, what we've seen over the past six years has been
a three-year period (1999-2001) during which gold was modestly
weak against the US$ and strong against other major fiat currencies
such as the euro, followed by a three-year period during which
gold was strong against the US$ while barely holding its own
against most of the other major currencies. These two periods
are identified on the below chart of the euro gold price.
Gold's performance over the past 6 years tells us that the
fiat currency system is not yet in trouble; that all we've
seen, up until now, is a shift in investor preferences WITHIN
the system. What has happened could be likened to participants
in the US stock market favouring tech stocks during one period
and financial stocks during the next, with the S&P500
Index remaining stable throughout.
As long as the euro continues to be seen as
a good alternative during those times when confidence in the
US$ is falling and as long as the US$ continues to be seen
as a good option during those times when the euro looks unattractive,
the sort of huge gains in the gold price that gold bulls like
ourselves expect to see at some point over the next few years
will not materialise. What will really be needed in order
for such gains to occur will be a general loss of confidence
in fiat currency. And by the way, such a loss of confidence
is not something we hope will happen, it's something we think
will be unavoidable if current monetary and fiscal policies
are continued (which they almost certainly will be).
A clear signal that the aforementioned loss
of confidence was in progress would be the US$ gold price
trading above 460 at the same time as the euro gold price
was trading above 350 (the 2002 peak); in other words, gold
trading above the bull market highs achieved to date in terms
of both the US$ and the euro.
If our forecast for a 6-12 month rally
in the US$ proves to be correct then the sequence is likely
to be a break above 350 by the euro gold price during 2005
following by a break above 460 by the US$ gold price in 2006.
That is, what we expect to see this year is an upside breakout
by the euro gold price from the multi-year consolidation pattern
shown on the above chart. Conversely, if it turns out that
we are right about the US$ rally but gold simply continues
to tread water against the euro (if gold goes down against
the US$ by about the same amount as the euro) then we are
probably still a considerable distance (years) from large
confidence-related gains in the gold market.
***
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