The deficit, the economy and the price of gold
April 16, 2004
According to the Wall Street Journal interest rates
are rising on fear that the economic recovery is spurring inflation.
Hmmm…
It’s unquestionable that this month’s
increase in interest rates is due to the recently released economic
numbers, and that higher interest rates gave the dollar a boost,
which in turn caused the gold price to decline.
I suppose the thinking goes that if the US economic
recovery is gathering steam then US assets will become more attractive
to foreign investors, and an influx of foreign capital is good for
the dollar. Or, a stronger economy can sustain higher interest rates
and higher interest rates obviously increase the return on fixed
income securities (e.g. bonds), which in turn will draw foreign
capital into the country boosting the dollar. Either way, or both
ways, a better performing economy is good for the dollar.
The first thing to consider is that while the Federal
Reserve sets the overnight rate (the cost for banks to borrow money
overnight), and gives the market guidance with respect to where
it would like to see interest rates heading, it is ultimately the
market that determines interest rates.
Interest rates are nothing more than the yield on
fixed income securities, mainly US Treasury bonds. For example,
the ten-year interest rate is the current yield on a ten-year US
Treasury bond. If the ten-year bond price drops, the yield on the
bond increases since the coupon rate (the amount paid as a percentage
of the bond’s face value) remains constant. Since the yield
is the same as the interest rate, a decline in bond prices is the
same as an increase in interest rates.
Now, we also know that the US government is running
a five hundred billion dollar annual budget deficit that has to
be financed by issuing more US Treasury bonds. So it’s no
secret that the world is going to have to absorb more US debt. If
anything, the Budget Deficit is likely to grow in size as time goes
on. We can, therefore, also expect an increasing amount of new government
bond issues to hit the streets every year.
An increase in supply causes a decrease in price --
no revelation there. An increase in bond issuances causes bond prices
to fall, thereby increasing bond yields and raising interest rates.
Furthermore, bond funds are some of the largest funds in the world,
and they are almost all on margin… lots of margin. A small
increase in interest rates can have a dramatic effect on bond prices
and the leverage of margin can turn that into a devastating blow
to bond holders.
With the prospect of five hundred billion dollar’s
worth of bonds (or more) being issued every year to finance the
Budget Deficit, on top of the already staggering amount of US debt
outstanding, bond investors and traders must have been biting their
nails for several months now, waiting for the exit signal.
The increase in consumer spending and the prospect
of more Americans finding jobs were seen as indications that the
economic recovery might be gaining traction. A stronger economy
could augur a return of inflation, and inflation would be the death-nail
for bonds. Bond managers have been glaring relentlessly into their
computer monitors lately for anything that might bode ill for bonds.
The recent economic news was adequate and bond prices hit the skids.
But in spite of what the popular press would like
us to believe, the US economy is very fragile. It is riddled with
debt and a hike in interest rates is therefore its Achilles’
heel. The Budget Deficit assures us that bond prices are going to
remain under pressure for the foreseeable future. That means that
interest rates are going to continue to rise for quite some time,
and could quite conceivably hit double digits before this cycle
is over.
Higher interest rates are more likely than not to
scuttle the fragile US economic recovery and a stagnant, or declining
economy will unlikely result in a stronger dollar. So, in spite
of this week’s rise in the dollar, and associated decline
in the gold price, the longer-term outlook for the dollar remains
bearish and the outlook for gold remains bullish.
In the short-term, however, you have to ask yourself
how long it will take for an increase in interest rates to start
impacting the economy -- in a noticeable way. It could take months,
perhaps even a year, or more, before the economy buckles under the
pressure of higher debt-service costs. In the meantime we could
easily see the dollar rally, or at least maintain ground for a while.
If nothing else, we can expect a dramatic increase
in volatility in the gold price and almost all other metals and
commodities, as all commodities that are priced in dollars are sensitive
to the dollar’s exchange rate.
In the medium to long-term, the US Trade Deficit is
also still looming out there, in addition to the negative impact
that higher interest rates will have on the economy and the dollar.
As previously discussed (see: The Greater Depression, January 30,
2004), the Trade Deficit itself is extremely bearish for the US
economy and the dollar. Having these dual deficits, especially in
light of the fact that they both run in the order of half a trillion
dollars each, is a virtual guarantee that the dollar will fall and
the gold price will rise (in US dollars).
In the March 19th Column I pointed out that the gold
market, and gold related securities, had become expensive. The recent
decline in both markets has corrected that to some extent and has
made several investments more attractive.
Market disruptions like the current one are wonderful
opportunities to increase our exposure to those investments that
we really like: in my case a select portfolio of junior exploration
companies. For my own portfolio (and I discuss my own investments
with subscribers to my newsletter: www.paulvaneeden.com) I have
been selling stocks that I do not consider core holdings, and I
have been buying stocks that I feel offer good value. Because my
investment decisions are mostly value driven I am quite content
to hold certain stocks for several years.
Counter-cyclical bear trends in a secular bull market
are a reality we must accept, much like death and taxes. Learn to
live with them and, if possible, profit from the lower prices that
now prevail. But don’t be surprised if the gold price continues
to fall even further -- in the short term at least. And don’t
be discouraged if the gold price remains in the doldrums for while.
In the longer-term, I am still as confident as ever that we will
see gold at over a thousand dollars an ounce.
Paul van Eeden
PS Given the recent activity in the gold market, and
the increased volatility that is likely to follow, I suspect it
will be worthwhile attending one or two gold-related investment
conferences this year. I will be speaking at both the Calgary conference
later this month and the London Investment Conference in the first
week of May (see sidebar for details). These conferences are also
a great venue to meet in person, especially the workshop I will
host in Calgary. I hope to see you there.
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
investment publication. For more information please visit his website (www.paulvaneeden.com)
or contact his publisher at (800) 528-0559 or (602) 252-4477.
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