Inflation is up and gold is down. What's going on?
March 24, 2005

On Tuesday the Federal Reserve raised its target for the Federal Funds rate -- the interest rate that banks charge each other for overnight loans -- by one quarter of a percentage point to 2.75%. The move was widely expected and the Fed indicated that it would continue to increase interest rates at a “measured” pace. The word “measured” was the focal point, since it indicates that interest rates are likely to continue to rise at one quarter of one percent for the foreseeable future. It means the Fed is not too worried about inflation yet.

But the Fed did say in its statement on Tuesday that “…pressures on inflation have picked up in recent months…” The market is taking that to mean that the days of “measured” interest rate increases could be drawing to an end. The inference is that interest rates might well start rising more rapidly in the future.

But if the threat of inflation is looming, and interest rates are rising, why is the gold price falling?

The answer is simple: the gold price in US dollars is reflecting changes to the US dollar exchange rate. As I wrote on March 4 (you can read the article on my website at www.paulvaneeden.com in the Commentary section), gold is not the main act. The prospect of rising inflation in the US is interpreted to mean that US interest rates are going to rise as well. Since higher interest rates attract more capital (better return on investment) the supposition is that the dollar will strengthen as foreign capital flows into the US bond market. In anticipation the dollar is therefore rallying and, by extension, the gold price in US dollars is declining. It’s not just the gold price that’s falling in US dollar terms. The price of oil and other commodities have also declined in dollar terms as the dollar rallied this week.

So the fact that the gold price dropped during the past few days amid all the talk of rising inflation didn’t really come as a surprise. Nor do I think it’s very material. What is important is that even though the Fed raised its target for the overnight rate, which impacts short-term interest rates, long-term interest rates actually declined this week. That’s because money is moving into bonds.

The prospect of higher inflation and rising interest rates does not bode well for the stock market and when stocks are perceived to be risky there is usually a flight to bonds, which are generally perceived to be safer. Higher interest rates will stymie the fragile US economy and when economic growth peters out I fail to see why foreigners would continue to invest in the US at the same rate as in the past. So even though the currency markets are optimistic about the prospect of continued foreign investment, I think it’s misplaced optimism.

I don’t know how long this rally in the dollar will last. Actually, I hope it lasts a while longer. As the dollar exchange rate increases the gold price in US dollars will drop, and since most investors who invest in gold related equities are fixated by the US dollar gold price, it means that gold stocks will get slaughtered. I do hope that happens, because I have cash that I’d like to invest, and I can think of no better speculation than to buy gold related investments as the gold price falls.

Regardless of how long the dollar rally lasts, it is still a counter-cyclical rally in a dollar bear market. The dollar will head lower soon enough and when it does, the gold price will start to rise again. As I’ve said in these pages so many times before, the next major downward move in the dollar -- and hence upward move in the gold price -- will not occur until the dollar falls in conjunction with rising interest rates.

It is perhaps counter-intuitive and not widely anticipated that the dollar will fall while interest rates rise, but that’s exactly how major events occur in the market: unexpectedly. For more on the topic of rising interest rates and a falling dollar I suggest you read the article “Dollar weakness and higher interest rates: how it works” on my website at www.paulvaneeden.com under the Commentary section.

In the meantime I’m just going to sit back, relax, and watch what happens. Most likely this rally in the dollar will peter out rapidly and the gold price will resume its upward trend. If it doesn’t, I suspect we’re going to get some real bargains.

As a side note, we got a tremendous response to the videotaped conversation between Robert Bishop, Adrian Day, Rick Rule and myself. The server hosting the video clip often became overloaded causing the video to terminate prematurely for some viewers. The webmaster in charge of the project has assured me that there are no other problems and suggests that you try again if you had problems viewing it last week, as the traffic should have subsided somewhat by now. The video is available at http://www.resourceschannel.com/video/pdac3_analysthourpve_1showmeta.wvx.

Paul van Eeden

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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