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
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
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
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
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