A Gold Bear’s Comments

Interesting comments on gold from Kitco’s Jon Nadler in an interview with Hard Assets Investor. Nadler argues that gold is not, as so many believe, in a bull market. His thesis:

• A true bull market in gold is driven by four factors – demand greater than supply, poor performance in financial assets like equities, stronger inflation readings, and an increasing gold price in all major currencies.
• The current rally in gold has only one leg, a falling USD, against which gold is an imperfect hedge. Gold is also an imperfect hedge against inflation, especially the stubborn, single digit kind. It’s much more effective against hyperinflation.
• Gold mine and scrap production continues to run at a historically healthy rate, with large supplies coming into the pipeline. On the financial side, industry re-hedging is likely to occur at some point, given the high historically high nominal price of gold.
• Gold has a very uncertain demand picture, with notable declines in industrial and jewelry fabrication, and India becoming a net exporter for the first time since 1980. “Wishful thinking” is embodied in expectations that demand in China will push gold substantially higher.
• The current gold price rally is “pure froth” driven by investment funds. If fundamentals don’t support investment price targets, a nasty correction could ensue.

Nadler believes that gold could go as high as $1,200, but that on fundamentals, its fair value is between $680 and $880 per ounce. His essential argument was that “gold has a place in the portfolio, and it absolutely deserves respect—but don’t get carried away.”

We largely agree with his view, but our take on gold is more macro/finance oriented. We believe that the interplay between the USD and hard assets tends to reflect interactions between interest rates (the Fed and credit markets), financial markets (hedgers and speculators),  and the real economy. While the Fed may look easy on a historical basis, this is only part of the picture – you have to look at balance sheets and expectations in the financial and non-financial economies to assess whether a central bank is easy, neutral, or tight. To us, the Fed appears to be easy relative to certain areas of the financial markets, which could help to explain the crowded short-USD, long-gold trade (Nadler’s “froth”). And as we’ve pointed out many times, the Fed is probably too easy relative to some parts of the real global economy, which foreign exchange rate management can’t completely overcome (in fact, it can often exacerbate global inflationary pressures). But…

• Relative to the U.S. and many other developed economies, the Fed is not terribly easy.
• The fallout from the credit crunch should actually support demand for the USD, at least domestically, as debtors should have a higher marginal demand for units of currency than ounces of gold. This and many other factors should take USD hyperinflation fears off the table. As Warren Mosler and Matthew Forstater have defined it, “hyperinflation is the condition in which the private sector no longer desires the currency unit.” This doesn’t even remotely describe the condition of the U.S. private sector today.
• Credit facilities from Fed and Treasury, and quantitative easing by the Fed and other central banks, are not necessarily inflationary. Put simply, if injections of new banking reserves fall short of the capital losses incurred during the crisis, they do not constitute ‘inflation of the money supply’. Yes, the numbers on the Fed’s balance sheet are eye popping. But so were (are) the credit losses during this crisis!
• Demographics, policy uncertainty, risk aversion, public deficit phobias, etc,  should all tend to lower normalized U.S. economic growth over the coming decade. Demographics and policies have been a problem since the beginning of this decade, and probably won’t change until the end of the next one (in fact, policies that might have been seen as problematic in the 1980s or 1990s could be more optimal in the 2000’s and 2010’s, which would require that deficit hawks pull their claws in a bit; otherwise, it will mean less room for the Fed to raise interest rates; we hope to write more on this topic soon).

Not one of these factors argues for a parabolic move in the gold price (though it certainly could happen, at least temporarily - again, think Nadler’s “froth”). That said, there are smarter people than us who are still hugely bullish on precious metals and catastrophically bearish on the USD. But the trade’s a bit too crowded for us (our clients do have some exposure to ‘less crowded’ assets that should perform well if gold does).

URLs:

http://www.hardassetsinvestor.com/features-and-interviews/1836.html?tmpl=component&print=1&page=

http://www.hardassetsinvestor.com/

http://www.epicoalition.org/docs/general2.htm

http://www.marketwatch.com/story/gold-bears-gathering-but-gold-bulls-defiant-2009-10-19

http://news.goldseek.com/SpeculativeInvestor/1242109080.php

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