KitcoKitco
navigate¬  
Profile Website
Recent Articles ¬
Listing of Articles >>

 
Printer Friendly

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.

Disclaimer

This letter/article is not intended to meet your specific individual investment needs and it is not tailored to your personal financial situation. Nothing contained herein constitutes, is intended, or deemed to be -- either implied or otherwise -- investment advice. This letter/article reflects the personal views and opinions of Paul van Eeden and that is all it purports to be. While the information herein is believed to be accurate and reliable it is not guaranteed or implied to be so. The information herein may not be complete or correct; it is provided in good faith but without any legal responsibility or obligation to provide future updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility, or assumes any liability, whatsoever, for any direct, indirect or consequential loss arising from the use of the information in this letter/article. The information contained herein is subject to change without notice, may become outdated and will not be updated. Paul van Eeden, entities that he controls, family, friends, employees, associates, and others may have positions in securities mentioned, or discussed, in this letter/article. While every attempt is made to avoid conflicts of interest, such conflicts do arise from time to time. Whenever a conflict of interest arises, every attempt is made to resolve such conflict in the best possible interest of all parties, but you should not assume that your interest would be placed ahead of anyone else’s interest in the event of a conflict of interest. No part of this letter/article may be reproduced, copied, emailed, faxed, or distributed (in any form) without the express written permission of Paul van Eeden. Everything contained herein is subject to international copyright protection.


Your Feedback.
You will stay on this page after you press "submit"