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 available.

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 alone.

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 to rise.

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 reserves.

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 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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