Lower gold prices?
October 15, 2004

As long-time readers of this column know, I ascribe most of the changes in the gold price to changes in the US dollar exchange rate. In the past four weeks we have seen an increase in volatility in the gold price as a result of an increase in volatility in the US bond market.

What does the bond market have to do with the price of gold? A lot!

When US bond yields increase, US bonds become more attractive to investors. When foreign investors buy US bonds, they need to convert their currencies into US dollars, thereby generating demand for dollars. So when US bond yields increase, the US dollar strengthens. Because the gold price in US dollars is primarily a function of the US dollar exchange rate, the gold price typically declines when the dollar strengthens and vice versa. Therefore, an increase in US bond yields usually results in a lower US dollar-gold price.

The weakness in the US economy is becoming more apparent as time goes by. The general consensus is that a weak economy cannot sustain higher interest rates, and since many people believe the Federal Reserve will make sure nothing bad happens to the US economy, investors have been buying bonds in anticipation of falling interest rates.

Because investors have been flocking to bonds the yield on ten-year US notes has declined from 4.8% in May to just barely more than 4.0% this week (the yield got as low as 4.04% yesterday). As a result of the declining bond yields the dollar has declined by 4% against both the euro and the yen since mid-May. And, as you may know, the low for the gold price this year was also around mid-May -- not by coincidence. Since May the gold price has increased by about ten percent.

I did not expect the dollar to weaken much this year and therefore did not expect the gold price to increase as much as it did. The incumbent Administration usually does its best to portray the economy in the best possible light during an election year. So I expected both the dollar and the gold price to remain essentially flat until after the election.

The fact that interest rates have fallen as much as they have is a clear indication that the economy is in serious trouble. It is also confirmation that what I have been discussing here over the past year regarding the US economy is not far off the mark.

But while the bond market seems to corroborate my thesis about the state of the US economy, the decline in bond yields has introduced an element of risk for gold investors.

Bond yields have declined because of the weak US economy, but, according to the Wall Street Journal, many bond investors are now betting on higher bond yields, not lower ones.

It could be that investors are expecting the economy to improve, although I find that hard to believe. It is more likely that investors are betting on lower bond prices (higher yields) because of the soaring US budget deficit that has to be financed by issuing more bonds. As the supply of bonds increases, bond prices will come under pressure and bond yields will rise.

Although it will be devastating to the economy such a rise in bond yields could occur even if the economy continues to weaken. In the initial stages of an increase in bond yields we should see the dollar rally, and that will mean a decline in the gold price.

I have long held the view that the gold price will not sustain a meaningful rally until we see the dollar decline in the face of rising US interest rates; and by that I do not mean an increase in the Federal Funds rate, I mean an increase bond yields.

The fact that bond investors were caught off-guard this week when bonds rallied (and rates declined) could be an indication that the bond market is getting ready for a decline and the risk of decline in the gold price is increasing.

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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