Here is a modified extract from commentary posted at www.speculative-investor.com on 29th June 2003:
Determining gold's long-term trend involves analysing the things that affect the investment demand for gold. When the conditions are in place for a revival of investment demand or for a continued rise in investment demand, the long-term trend for gold is positive.
The things that affect the investment demand for gold are the same things that affect the investment demand for the US$, but in the opposite direction. In fact, gold and the dollar can be considered to be at opposite ends of a seesaw - as various financial, economic and political forces combine to push one higher, the other heads lower. This doesn't mean that the market prices of gold and the dollar are necessarily going to move in opposite directions during any given day, week or month, but it does mean that there is a very strong inverse correlation between gold and the dollar. This strong inverse correlation is evident regardless of whether we consider the performances of gold and the dollar over the past 2 years, 5 years, 10 years, or 30 years.
The investment demand for the US$, and hence gold, is influenced by inflation expectations, the US current account deficit, the US budget deficit, and the expected future returns on dollar-denominated assets and debt. And, financial market signals that trend changes in investment demand have occurred or are about to occur can often be observed in such things as the rate of exchange between the US$ and the Swiss Franc, the trend in the yield spread (the way long-term interest rates are moving relative to short-term rates), and the inflation-adjusted interest rate.
It was possible to determine, in real time, that the trend for gold was turning higher during the final quarter of 2000. In fact, we managed to do exactly that. Based on an analysis of the factors that determine the investment demand for gold we can also confidently conclude, at the current time, that the trend for gold is still bullish and is very likely to remain bullish for a lot longer. We discuss, below, two of the reasons why this is so.
Gold Stocks and Interest Rates
We often talk about the tendency of gold stocks to move in the same direction as the yield spread (the yield on the 30-year T-Bond minus the yield on the 13-week T-Bill). The idea that the yield spread could be important for gold stocks first occurred to us when we were reviewing what took place during the 1985-1987 period. Specifically, in trying to figure out why the prices of gold stocks, as measured by the XAU, fell between March of 1985 and July of 1986 even though the gold price rose by around 20% over this period, we came across the relationship between gold stocks and the yield spread.
The below chart compares the XAU with the yield spread from the beginning of 1985 through to the end of 1987. Between March of 1985 and July of 1986 the gold price rose and the US$ fell, but the XAU continued to make new lows until the yield spread turned higher. The XAU then moved sharply higher with the yield spread until October of 1987, when it crashed with the overall stock market.
Below is a chart comparing the TSI Gold Stock Index (TGSI) with the yield spread between March of 2000 and July of 2003. This chart doesn't show it, but the gold price bottomed in August of 1999 while the average gold stock didn't bottom until about 15 months later in November of 2000. As was the case during 1985-1986, gold stocks continued to make new lows until the yield spread turned decisively higher. Between November of 2000 and May of 2002 gold stocks and the yield spread trended upward together, while over the past 13 months they've both moved sideways.
The above chart shows that the May-November 2001 consolidation in the gold stocks ended when the yield spread broke out to a new high, and we think that a move in the yield spread above its April-May 2002 peak of around 4.1% would now have similarly bullish implications for gold stocks.
As at the end of last week the yield spread was 3.76%, having recently moved sharply higher due to the upturn in the bond yield and the on-going efforts by the Fed to keep short-term interest rates at a very low level. As long as the Fed maintains the downward pressure on rates at the short-end, any rise in long-term interest rates will be bullish for gold stocks. At some point, of course, the Fed will be forced by the market to drive short-term rates up at a faster pace than long-term rates and the trend for gold stocks will no longer be bullish, but we are a long way from that point. As discussed in previous commentaries, long-term interest rates are likely to move much higher over the coming 12 months and the Fed will, as always, be slow to react to the changing circumstances. As such, the yield spread is likely to move considerably higher before a trend reversal occurs.
The Dollar
The US$ can rise in the face of a current account deficit for a very long time, so the current account deficit cannot be used to determine when a US$ bear market is going to begin. However, once a US$ bear market is set in motion it tends to continue until the quarterly US current account moves into surplus (refer to the below long-term chart comparing the trade-weighted dollar index with the quarterly balance on current account). Therefore, if we assume that a US$ bear market is in progress, a reasonable assumption considering the price action and the fact that the dollar remains over-valued based on some important measures, then this bear market has a long way to go before it ends. This is because the current account deficit is still hitting new all-time highs.
As an aside, the below chart shows the current account in billions of dollars. If, however, we look at the current account deficit as a percentage of GDP, this is what we get:
1. The deficit peaked in Q1 1978 at 1.3% of GDP
2. The deficit peaked in Q4 1987 at 3.4% of GDP
3. In Q1 2003 (the latest available data), the deficit was 5.1% of GDP.
The decline in the US$ that has occurred over the past 18 months has not yet had any noticeable effect on the current account balance. This is not, however, unusual or unexpected. For starters, most of the decline in the dollar from its 1985 peak occurred while the current account deficit was still expanding. Also, a large and growing component of the US current account deficit is the trade deficit with China. The Chinese currency is pegged to the US$ so a weakening US$ does nothing to reduce this trade deficit. All it does is give China a greater competitive advantage over other exporters to the US.
In the absence of a substantial upward re-valuation of the Chinese currency, the only thing that will make a big difference to the US current account deficit is a reduction in US consumer spending. However, the Fed and the US Government are working overtime to boost consumer spending, the Fed by holding short-term interest rates near historic lows and by threatening to force long-term rates lower and the government by providing tax cuts. In other words, the actions of policy-makers will tend to increase the current account deficit and hence extend the dollar's bear market. Their actions are also, by the way, postponing the time when the next sustainable economic expansion can begin, although that is probably of little concern because the overriding goal of current policy is to ensure victory in next year's elections.
