A Gold Bull Market
November 28, 2005
As long-term readers of my commentaries know I am
quite confident that the gold price will exceed $800 an ounce within
the next few years primarily due to continued dollar devaluation
on foreign exchange markets, as has been the case since 2001.
But it is becoming more and more difficult to explain
recent gold price activity purely in terms of the US dollar exchange
rate. While both US dollar inflation and a decline in the US dollar
exchange rate will cause the gold price in US dollars to increase,
the gold price is currently rising across the board of currencies.
Of course, it is to be expected that the gold price
will, over time, rise against all currencies because gold inflation
is typically less than the inflation rates of almost all fiat currencies.
The question is whether the current increase in the gold price is
merely a result of the inflation rates of fiat currencies or whether
there are other influences that are causing the gold price to rise
more rapidly than inflation alone would dictate. This is a very
difficult question to answer since the data required is not readily
I have been able to calculate what I think the gold
price should be in US dollars because the United States regularly
publishes a wide range of data. For the purpose of calculating a
theoretical gold price I have found M3 data most useful, since it
is the broadest measure of money supply. However, the Federal Reserve
announced that it will cease to publish M3 data as of March 26 next
year. The Fed told economic reporters that M3 is being discontinued
because it's too costly to produce, irrelevant for setting monetary
policy, and a burden for banks to report.
The fact that the Federal Reserve will discontinue
M3 could have more to do with their desire to obscure real US dollar
inflation than the reasons they stated. Collecting M3 data cannot
be that costly, or that big of a burden on banks, given all the
other pointless bureaucracy and paperwork that banks have to deal
with anyway. Besides, much of the data for M3 will still be collected,
just not compiled into M3 and published. The US dollar gold price
correlates strongly to the difference between M3 inflation and above
ground gold inflation and if the Fed stops producing M3 figures
I will not be able to continue calculating gold price targets the
way I used to.
I find it quite interesting that the Federal Reserve
decided to stop producing M3 figures precisely at a time when M3
seems to be exploding. The average annual increase in M3 during
the past 20 years was 5.9%. However, during the past 3 months, M3
has increased at an annualized rate of over 10%. Given that the
US dollar is also the reserve currency of the world, such high inflation
rates for the dollar could impact more than the value of this currency
The US dollar still has a long way to fall on foreign
exchange markets and Federal Reserve shenanigans can only postpone
the inevitable. However long it takes, the dollar exchange rate
has to be corrected to reflect US inflation and US industrial competitiveness,
the latter of which is rapidly deteriorating relative to Asian competitiveness.
As the dollar falls, the gold price in US dollars will continue
However, there are other developments that could impact
the gold price over and above the effect of fiat currency inflation.
We are witnessing a change in central bank behavior.
Last year Argentina bought 42 tonnes of gold and now Russia wants
to increase the gold in its reserves from 5% to 10%. The Moscow
Times quoted President Vladimir Putin this week as saying he supported
the Central Bank in paying greater attention to gold in its foreign
During the 1990s the gold price would drop sometimes
by tens of dollars an ounce after the announcement of central bank
sales, and while the actual sales had very little impact on the
gold price their effects on investor psychology were clearly evident.
I suspect the same is going to be true of central bank purchases,
with one exception: Given the large foreign reserves being created
in countries such as China and Japan, we could see a dramatic increase
in the gold price if such countries attempted to balance their reserves
with gold, as Russia is contemplating.
Oil producing nations are also seeing their foreign
reserves swell given the increase in the oil price. If they, too,
start adding more gold to their foreign reserves that could also
impact investor psychology and the gold price.
The problem is that while a gold price forecast based
on differential inflation rates and exchange rates has a rational
basis and conforms to quantitative analysis, a market based on official
sector purchases and the emotional behavior of investors does not.
But whether the gold price increases solely as the result of a declining
US dollar, or whether additional factors come into play, the end
result is a higher gold price.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
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