When will the gold bull market resume?
May 14, 2004
The next section of my conversation with Doug Casey
and Rick Rule deals primarily with non-precious metals but because
of the recent decline in precious metals prices I decided to post
the letter that I sent to my subscribers last week. I’ll continue
the interview transcript next week.
Typically I restrict my subscription-based newsletter
to discussions about the specific companies I buy and sell, and
the reasons why (for more information about my newsletter please
visit www.paulvaneeden.com). Last week, however, I felt compelled
to comment on the metals markets.
From 1998 to 2002 I firmly believed that gold would
rise significantly, and exceed four hundred dollars an ounce, as
a result of dollar-weakness. The dollar did weaken, and we can think
of the increase from $250 to $400 as the first leg of a major gold
bull market (in dollar terms). The second leg up will most likely
take gold to over five hundred dollars an ounce. All bull markets,
however, are interrupted by counter-cyclical corrections.
I’m not a witch doctor, so I can’t tell
you the date on which gold will resume an upward course, but I can
tell you what needs to happen before it does.
The gold price is still very much a function of the
US dollar exchange rate. The dollar is far more important than Central
Bank sales, Indian jewelry demand, hedging, de-hedging, or anything
else. And right now the relationship between interest rates and
the dollar is controlling the gold price.
Here is a recap: the gold price in US dollars is a
function of the US dollar’s exchange rate. If the dollar strengthens
the gold price declines (this is because the average gold price
in the world remains fairly constant, rising gradually in proportion
to total fiat money creation). The rise in the gold price from 2001
until recently occurred because the dollar lost value on foreign
exchange markets -- nothing more. The recent decline in the gold
price is due to temporary strength in the dollar, on the back of
higher interest rates, and the prospect of them rising even further.
US interest rates actually bottomed around June last
year, even though the trend appeared to continue downwards after
then. In March this year there was another significant up-tick in
interest rates, which strengthened the dollar and put pressure on
the gold price. The recent decline in the gold price is solely a
result of that increase in interest rates and the resulting increase
in the dollar exchange rate.
Higher interest rates in the US are a foregone conclusion,
guaranteed by the US Budget Deficit. The Budget Deficit has to be
financed by issuing bonds at a rate of five hundred billion dollars
a year. There is no reason to believe the Budget Deficit will decline
anytime soon; on the contrary, it is more likely to increase. Obviously
issuing five hundred billion dollars’ worth of bonds every
year will have a negative impact on bond prices, hiking interest
rates. Think of it this way: the annual Budget Deficit equals about
seven percent of the total amount of outstanding Treasury Securities.
Every bond investors and bond trader out there knows that the total
amount of Treasury Securities outstanding is going to increase by,
at least, seven percent per year for the foreseeable future. That’s
an enormous amount of overhanging supply, and the reason why interest
rates have started moving up.
Higher interest rates are the Achilles Heel of the
US economy. We have too much consumer debt, too much credit card
debt, too much mortgage debt, too much corporate debt and too much
government debt. Higher interest rates are not only going to choke
economic growth in the US, they could easily precipitate a collapse
in real estate and the stock market. Don’t, for a minute,
believe that the worst is behind us.
The probability of the US economy in its current state
experiencing economic growth while bearing the weight of higher
interest rates is slim. Even Alan Greenspan is worried about it.
Last week’s Wall Street Journal (Online Edition)
reported that Greenspan said the US Budget Deficit threatens the
nation’s economic stability. There is only one reason for
him to worry about the Budget Deficit. He knows that it will cause
interest rates to rise and that higher interest rates will kill
any chance this economy has of averting a serious downturn.
But let’s not forget about the Trade Deficit,
which is also in the order of five hundred billion dollars. The
Trade Deficit has to be financed with foreign investment and I find
it very, very hard to believe that the United States will continue
to attract half a trillion dollars in foreign investments every
year. Especially when economic growth stagnates, or declines, under
the burden of outstanding debt and higher interest rates.
Even though the US debt problem has been looming for
decades, a crisis has not yet materialized because US bonds have
been rising since 1981. The resultant decline in interest rates
not only mitigated the impact of outstanding debt, but also enabled
the debt to grow exponentially. Now, however, we are entering a
period of increasing interest rates in an environment of severely
compromised credit quality and a fragile economy.
The bond market has already figured out that the bottom
is in; the twenty-three year bull market in bonds is over and from
here onwards interest rates go up. The currency market, on the other
hand, has not yet figured out that higher interest rates will spell
the end of the US economic boom. When it does, the dollar will commence
a second decline in its secular bear market, and that will cause
the gold price to rise.
Here is the key: we need dollar-weakness on the news
of higher interest rates before the gold market resumes a sustainable
upward trend. Currently the dollar is strengthening on the prospect
of higher interest rates, but that will change.
It’s an election year in the United States,
so I fully expect to see government intervention in both the currency
and bond markets, in an attempt to mitigate a decline in either.
The government cannot, however, keep the game up for very long because
of the Budget Deficit. So the rally in the dollar (and the downturn
in gold) is unlikely to last much beyond the end of the year and,
given the precarious state of the government’s finances, it
may not even last that long.
In the meantime use this market to your advantage:
sell stocks that you now regret you bought in the first place and
replace them with the shares of companies you are glad went down,
so that you can buy more at a lower price. That’s what I am
doing, and it’s why this downturn in gold doesn’t bother
me in the least.
If you want to know specifically what it is I’m
selling, or have sold, and what I am currently buying, you should
subscribe to my newsletter. Please visit www.paulvaneeden.com
for more information.
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
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