Why I’m Pessimistic on the Economy . . . and Optimistic on Gold

The following rather lengthy post is the full text of my June 9th speech, unabridged and unedited, to the Mines and Money Conference in Beijing, China:

To begin with my conclusions, I believe we will continue to see gold generate lofty returns for years to come.  By year-end, I expect we will see gold hit $1500 an ounce — and sometime in the next few years $2000 seems very likely . . . with $3000 or higher quite possible.  And, in my mind, these are quite conservative forecasts.

At the crux of my bullish outlook is this:  History demonstrates time and again that excessive government spending, rapid money supply growth, and negative real interest rates are always accompanied or followed by rising gold prices.

And these are precisely the conditions that have characterized the U.S. and European economies for the past few years . . . and why gold prices have been and will continue to trend higher.

But even with “gold-neutral” macroeconomic policies in the older industrialized nations, there are good, solid reasons to expect much higher gold prices for years to come.

Just so you know where I’m going, let me quickly list the top nine bullish factors that support this forecast — and then, in turn, discuss some of these bull points in more detail.

• First, as I just mentioned, inflationary U.S. monetary and fiscal policies — past, present, and future — along with the coming second dip in the U.S. business cycle.
• Second, Europe’s intractable sovereign debt crisis, which has greatly undermined the euro’s appeal as an official reserve asset . . . and is pushing the European Central Bank to pursue inflationary monetary policies.
• Third, moderate, well-managed rates of economic growth in the “gold-friendly” newly industrialized or emerging economies . . . especially, and most importantly, in China and India.
• Fourth, continuing — if not growing — interest by the official sector, principally the central banks of a number of newly industrialized or emerging nations to diversify official reserve assets.
• Fifth, rising private-sector investment demand in the “western” older industrialized nations reflecting fear of inflation, currency depreciation, and a loss of confidence in governments to deal effectively with today’s economic challenges.
• Sixth, rising long-term saving and investment demand for gold from India, China, and other gold-friendly nations enjoying healthy growth in household incomes — growth that is likely to continue for the next several years.
• Seventh, the continuing maturation of what I call the “gold-investment infrastructure” — in other words the development of new gold investment products and channels of distribution in many important geographic markets.
• Eighth, the continuing long-term downtrend in world gold-mine production for at least the next five to ten years or longer.
• Ninth, the relatively small size of the world gold market compared to other capital markets — such as equities or currencies — so that even small shifts in portfolio preferences away from currencies, or equities, or real estate, for example, may have little price effect on these big markets but will have a relatively large, indeed profound, effect on gold.

Let’s look at some of these bullish factors more closely . . . beginning with the U.S. economy.

Despite relatively favorable data on retail sales, industrial production, and consumer prices over the past half year or longer, I believe the economic statistics will soon indicate a renewed cyclical downturn, an end to the recovery seen by most business and government economists along with rising price pressures.

What I see down the road for the United States and Europe is an extended period of stagflation — much like the 1970s, with below par business activity and continuing high unemployment along with above par price inflation led by rising prices for oil and other key commodities.

Stripping away the contribution to GDP growth resulting from the temporary federal stimulus programs (like the just-expired tax benefit to first-time home buyers) and the positive effect of inventory accumulation during the fourth quarter of 2009 and the first half of this year, leaves a gloomy picture of an economy that is dead in the water.

As Washington’s stimulus programs wind down — and with the inventory cycle not longer contributing to growth in Gross Domestic Product — the U.S. economy will stall . . . and, very possibly, sink back into recession.

In addition, there are other good reasons to fear a renewed business downturn and years of sluggish growth with higher inflation.

The United States economy depends on consumer spending — spending that typically accounts for about 65 to 70 percent of Gross Domestic Product.  But, American consumers are in no shape, mentally or fiscally, to continue spending at the pace of the past decade or two.  Here’s why:

Savings rates are rising as consumers spend less and save more to rebuild household balance sheets after years of excessive borrowing . . . and, as a precaution in uncertain economic times.  To be sure, high unemployment, the increasing duration of unemployment, and fear of future unemployment is enough for many households to cut back.

In addition, the declining value of household assets — including home prices and retirement savings invested in stocks and mutual funds is also discouraging consumer spending — something we economists call the “wealth effect.”

Consumer spending will soon take another hit when the tax cuts enacted nearly ten years ago under the Bush Administration, tax cuts that favored upper income brackets, expire later this year.

It’s not just consumers who are spending less:  State and local public-sector budgets are also in crisis across American.  With most states and cities legally prohibited from operating in deficit, falling tax revenues are beginning to trigger public-spending restraint — including layoffs, reduced benefits to workers and retirees, cuts in social programs, and so on.

Next we have the continuing squeeze on small- and medium-size businesses resulting from the reluctance of banks to offer credit and financing to this important segment of the economy.  Small- and medium-size businesses are the engine of economic growth and expanding employment — but they are dependent on lines of credit from America’s banks to run their businesses.  And, many banks have been and continue to be reluctant or unable to lend to this important sector of the economy.

And, let’s not forget the impact of Europe’s sovereign debt crisis — which is pushing a good part of the continent into recession or sluggish growth.  Just as in America, heightened uncertainty is causing consumers and businesses to curtail spending and investment . . . while attempts at fiscal restraint in some countries will cut directly into spending by households and businesses.

Europe’s downturn — aided by the fall in the euro against the dollar — will soon, and for some time to come, reduce the contribution to U.S. economic activity from America’s international trade.

You may be asking: “What does all this have to do with gold?”  Well, a lot, actually!

Disappointing U.S. economic activity will have serious detrimental consequences for the Federal budget deficit, for Treasury funding requirements, and for the U.S. dollar — all of which will benefit gold.

This “double-dip” scenario of renewed recession or merely slower than expected activity means:

First, the Federal Reserve, America’s central bank, will maintain near-zero interest rates for longer than most market participants generally anticipate.

Second, future U.S. Federal budget deficits will be significantly bigger than now expected as projected tax revenues fall short.  This will erode confidence in the dollar among those central banks and institutional investors who have traditionally bought our debt and financed our deficit — leading to higher medium- to long-term interest rates in the United States.

Third, even more pressure on the Fed to monetize a growing share of Treasury debt.

All of this will produce more inflation — and more demand for gold.

In the interests of time, I’m going to skip over a more detailed discussion of the European sovereign debt crisis — except to highlight three brief points:

First, the crisis has created fear and uncertainty about the future viability of Europe’s common currency, the euro.

Second, it has created and fear and uncertainty that some of Europe’s biggest banks, banks that have invested heavily in now-questionable sovereign debt, will be pushed to insolvency or require government bailouts.

Third, the euro — which had increasingly been viewed by central bank reserve managers a legitimate diversifier to reduce dollar dependence — has suddenly been tarnished and discredited as viable alternative reserve asset.

Together, these fears and uncertainties have touched off a gold rush of demand for physical gold investment products — small bars, bullion coins, and gold exchange-traded funds — by private investors, not only in Europe, but around the world.

This brings me to the official sector — and the increasing interest among some central banks to hold gold as a reserve asset, dollar alternative, portfolio diversifier, and investment asset.

Even before the euro’s sudden and surprising demise, some central bankers began to take a fresh look at the yellow metal . . . and, last year, a few countries even began adding to their official reserves.

After two decades of selling, at an average annual rate of some 400 tons per year, the official sector became a net buyer of gold in 2009, adding more than 425 tons to total official-sector holdings.  I believe the official sector continues to be an important net buyer of gold — and could easily add another 150 to 300 tons or possibly more this year with sizeable net purchases continuing for years to come.

As you know, last year the People’s Bank of China (PBOC) announced that it had purchase 454 tons of gold from domestic mine production since 2003 . . . but it did not include these acquisitions in its official reserve accounts until last April.

I believe that China continues to buy gold discretely from domestic mine production — but chooses to hold this metal “off the books” so to speak as periodic announcements of PBOC purchases and inclusion of this metal in its official reserve accounts would probably result in higher world market prices making subsequent purchases that much more expensive.

In contrast, Russia and recently Kazakhstan have bought gold from their own domestic mines — but unlike China have chosen to publicize their purchases each month, perhaps as a matter of prestige or to improve their appearance of creditworthiness in world financial markets, something that China and the PBOC need not consider.

Last year, India bought 200 tons “off the market” directly from the International Monetary Fund, which has a one-off program to sell 403 tons over several years to fund its own operating expenses and benefit its poorest members.  Sri Lanka and Mauritius also purchased small amounts last year from the IMF.  All three, like Russia, announced their purchases to benefit from the publicity and prestige that comes with owning gold . . . and, in the case of India, perhaps to make a statement that they’ve arrived as a big-league economic power.

The IMF has some 152.8 tons remaining to be sold under the existing program, having announced sales into the market this year of 38.5 tons through April.  Quite possibly some or all of this gold found its way into the vaults of one or another central bank preferring anonymity.  In any event, this metal was easily absorbed into the market without detrimental effect on the price.

In another twist, the China Investment Corporation, China’s largest sovereign wealth fund, announced purchases early this year of about 4.5 tons.  While not a central bank, it is likely that the investment had the blessing of the PBOC.  Interestingly, the CIC purchased this gold via the SPDR Gold Trust, the NYSE-listed gold ETF.

At the very least, even if a one-time isolated purchase, it further signals China’s very positive “pro-gold” official attitude . . . and gives private investors greater confidence to buy gold for their own saving and investment programs.

Another very important factor — one that has been especially apparent in recent weeks and months has been rising private-sector investment demand for gold from across the old industrialized world.

Private investors in the United States and Europe, both individuals and institutions, are buying more gold reflecting the same concerns and fears that are driving central banks to accumulate the metal.

They are increasingly concerned about the huge deficits and debt of governments on both sides of the Atlantic . . . and that accelerating inflation and depreciating currencies will eat away at their other savings and investments.

Just as the European sovereign debt crisis has gathered steam, we’ve seen a substantial rise in physical investment demand across Europe — from Germany, Switzerland, France, the United Kingdom and other countries — like the United States.  And, just as we’ve seen on earlier price advances, mints (like the United States Mint, the Austrian Mint, and others; refineries (that manufacture small investment bars); and precious metals dealers report very strong demand from retail investors, so much so that premiums on small bars and coins have risen in recent weeks.

Importantly, as in earlier big advances in this gold bull market, these are mostly long-term investors — and their purchases, unlike those of traders and speculators, are not likely to return to the market anytime soon.

Similarly — and perhaps even more important to the long-term outlook for gold — we have seen rising long-term investment demand from India, China, and other newly industrialized nations.

Gold has historically been a preferred medium of savings in India, China, and many of the other Asian countries.  As incomes rise, as more people enter the middle class, and the numbers of truly wealthy increase, it is only natural to see some of this money flow into gold.

Both India and China, because of their huge populations and the movement of millions of people each year from poverty to middle class, and from rural areas to the cities, have tremendous potential in terms of the volume of gold investment that will be purchased in future years.

For gold savings and investment demand in these countries to grow requires only moderate growth in personal income.  Inflation or financial market uncertainties are not required, though their presence may encourage even more savings-related demand.

I believe the economic outlook for in these countries is propitious for gold. Cautious measures to counter excessive speculation (in real estate or equities, for example), prevent overheating, restrain inflation and will keep these economies growing at moderate rates that will benefit gold demand in the years ahead.

Let’s take a closer look at each of these countries so important to the very bullish long-term outlook for gold.

As long as I can remember, Indian gold demand has always been extremely price sensitive — with rising prices quickly restraining purchases and often evoking a return flow of old scrap as holders of gold seek to take profits.  As a result, the ebb and flow of India gold interest has often had a significant effect on the world market — stopping strong rallies when Indians think the price is too high and establishing floors when they think prices have fallen enough.

But, importantly, we’ve seen the Indian gold buyer adjust to higher and higher price levels.  A year ago, reflecting India restraint, the world market had difficulty moving higher when prices neared $1000 an ounce.  Today, Indians are still buying at $1200 an ounce.  I see this behavior continuing — but at higher and higher price levels over the next few years.

But it’s not just prices that matter to the Indian gold buyer.  Indian demand is now picking up and momentum improving thanks to the country’s strong economic recovery, growth in personal incomes, and — as I’ll explain later — new distribution channels that are gradually “westernizing” India’s gold market.

Last year, in 2009, gold demand was hurt, not just by resistance to rising prices, but from poor monsoons, low crop yields, and greatly diminished demand from the gold-friendly agrarian sector for whom gold has always been a traditional form of personal saving.

Now, weather forecasters (who have a much better track record than even the best gold forecaster) are predicting good monsoons and more than adequate rainfall this summer, with abundant harvests this fall, and healthy gains in personal income . . . some of which will, as it always does, find its way into gold jewelry and investment products.

What can we say about China?

After more than five decades of prohibiting private gold investment, China’s government legalized private gold investment only some three years ago . . . and today private gold investment is not just legal, it is encouraged and endorsed.

Five decades of pent-up and unrealized gold demand, the development of gold spot and futures markets, the evolution of a national gold-investment distribution system through banks and other retail outlets, the growing Chinese middle and rise in wealth across the population, inflation anxieties, and the country’s long-standing cultural affinity to gold assures that China will have an increasingly important influence on global gold supply and demand trends — and a powerful positive effect on the metal’s price for years to come . . . and this doesn’t even take into account the on-going “official” or “government-related” purchases that I’ve already mentioned.

We also see some very important institutional and structural developments occurring in the world of gold.  New gold investment products and channels of distribution are making gold more readily accessible to more investors, both individuals and institutions, in more markets around the world.

For example, gold exchange-traded funds, that allow investors to purchase gold via an equity-like vehicle, were introduced only six years ago.  Now there are more than 18 such funds traded on many stock exchanges around the world — and a new gold ETF is just now being launched in Japan.  Since their introduction, the total quantity of gold held on behalf of ETF investors has grown to more than 1900 tons.  This is more than is held by the central banks of all but four countries.

Another example:  In China, private gold investment was legalized only three years ago after five decades of proscription.  Now, not only is gold investment legal, it is encouraged by the central government.  Five national banks have been authorized to trade gold and make gold investment products — small wafers, bars, coins, passbook programs and accumulation plans — available across China.  In addition to these banks, physical gold is also available to investors at stand-alone gold investment retail shops and at department stores.

Similarly, in India, we are seeing the introduction of new products in the past few years, including a gold ETF traded on the Mumbai Stock Exchange, as well as online physical investment products offered online by a number of financial service firms.  Beginning in September the postal service there will begin selling small coin-like medallions at post offices in rural agrarian communities where there is great interest in gold but a paucity of banks and financial firms for savers to purchase the metal.

These new products, distribution channels, and other advances in the gold investment infrastructure are resulting in a permanent upward shift in the demand curve for gold — so that the average price of gold, stripping away the big cyclical swings, will in future years be much higher than most of us would now imagine possible.

Well, I think I’ve already talked too long but I do want to make a point about declining world gold-mine production.

Global gold-mine production has been in a downtrend for decades.  Despite a small uptick last year and possibly again this year, the fall in world mine output will continue for at least for the next five years . . . and probably for years longer.

The ebb in mine production reflects many factors, including the depletion of existing deposits, the continuing drop in ore grades, the decline in operating depths at many mines, the rise in energy and labor costs, the expense and time required to meet increasingly restrictive environmental regulations, unfriendly government attitudes toward foreign investment in some gold-producing countries, and the lack of financing available to many gold-mining exploration and development companies.

Even if the expected leap in the price of gold triggers much more exploration and development . . . and even if new significant economic deposits are discovered . . . it can take five to ten years or longer to bring a large discovery into sizable production.

So there you have it, my reasons and analysis behind my positive outlook for gold.

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Speech to the 4th Annual China Gold & Precious Metals Summit

GOLD SITUATION & OUTLOOK:

How Monetary Policies, Investment Demand, Central Bank Interest, and Other Supply/Demand Factors Are Affecting the Market and the Metal’s Future Price

Shanghai, China — December 3, 2009

I’ve been asked to talk about the Gold Situation and Outlook - in particular how monetary and fiscal policies, private-sector investment demand, renewed central bank respect for gold, and other supply-demand factors are changing the market - and have important implications for the price of gold over the next few years.

The place to begin is with the U.S. and global macroeconomic situation - past, present, and future.

Easy Money is the Root

In my view, the root cause of the current world economic crisis has been decades of easy money, low interest rates, and a persistently expansionary monetary and fiscal policy by the United States - aided and abetted by China and the other major Asian exporting nations.

As a result, Americans have for many years been on a buying binge in the global marketplace, buying things we often don’t really need with money we don’t really have.

Now, however, many foreign lenders - both private and official - who have been financing America’s Federal budget and trade deficits are becoming increasingly uncomfortable pouring more and more good money after bad.

For at least the past quarter century America’s central bank, the Federal Reserve, has generally pursued an expansionary, low interest-rate policy that has favored economic growth and high employment above price stability and a stable currency.

During these years, every economic or financial-market crisis was met with another injection of liquidity into the banks and financial markets with interest rate often pushed down below the inflation rate to negative real rates of return.

The stock market crash of 1987, the Gulf War beginning in 1990, the Mexican Peso Crisis in 1994, the Asian Currency Crisis in 1997, the Long-Term Capital Management bankruptcy in 1998, the Internet Dot-Com Bubble in 2000, and the U.S. Housing Bubble that ended in 2007:

Each crisis was met with more money and lower interest rates - a policy that led many of the most reckless risk-takers to believe they could not lose.  Even if their investment and trading strategies went awry, the U.S. Federal Reserve was there to bail them out.

We never would have had the last stock market boom carry valuations to such heights without easy money.

We never would have had the U.S. housing boom without artificially low interest rates and without Fannie Mae and Freddie Mac promoting home ownership for everyone.

We never would have had the mortgage-backed securities debacle without easy money and low interest rates.  And, no one - especially foreign central banks - would have bought these and other sub-prime securities if they thought their money was at serious risk.

Unfortunately, America’s lenders are now realizing the “full faith and credit” of the United States isn’t what it used to be.

A healthy vibrant economy needs to clean out the dead wood from time to time.  Rather than allowing periodic recessions to purge the excesses of each prior boom or bubble, the Fed repeatedly stimulated the economy with massive doses of new credit, more liquidity, and lower interest rates.  Neither the Fed nor the politicians in Washington - both Republicans and Democrats - wanted a recession - and hardly anyone complained when the Fed just printed more money.

America’s False Recovery

Today, we should not be fooled by signs the U.S. financial crisis is now over.  The losses are still there . . . and still growing:  They’ve only been transferred from Wall Street and the private sector to the Federal Reserve and the U.S. Treasury.

Neither should we be fooled that the recession in the United States is really over and things are getting back to normal.  The U.S. economy is showing signs of life mostly because of massive injections of liquidity from the Fed, unprecedented fiscal stimulus by the U.S. Treasury, and inventory restocking.

No one really thinks the economy will continue to grow if the Fed removes the intravenous feeding tube.  With unemployment rising, household wealth diminishing, and continuing uncertainty about our economic future, American consumers are in no shape to start spending again.

Although many are talking about economic recovery in the United States, those that are seeing “green shoots” in my view are looking through “rose-colored” eyeglasses . . . and there is significant risk of a “double-dip” recession with further contraction and another collapse in U.S. equity prices yet to come.

While some of the Federal stimulus programs help businesses and households in the short run, they are all adding to the Federal budget deficit . . . and, in the long run, will result in more monetary creation, more inflation, and a weaker U.S. dollar.

We are in this mess today because America borrowed and spent too much, because we created too much credit, pumped out too much liquidity, and often kept interest rates too low- and our trading partners were willing to go along because it supported growth and employment in their own economies.

Defying common sense, the politicians and policy-makers in Washington are telling us the cure is more spending, more borrowing, bigger deficits, more credit, more liquidity and continued negative real interest rates.

How can this be?  It was too much liquidity, too much credit, too much spending, and too much borrowing that created the economic crisis in the first place.

Yet, Americans are told by mainstream economists and politicians that the prescription is more of the same - only in bigger doses.

Difficult Times Ahead

I don’t know what the prescription is . . . but I can tell you it’s not more of the same.  Would you tell a heroin addict to cure his addiction with more heroin, only in bigger doses?

However, what I do know is that difficult times lie ahead - not just for the United States but also for many of its creditors and trading partners.  Large budget deficits call for increased taxation at home - but tax increases are an anathema to Americans and there is only so much American voters will accept.

In lieu of actually paying down America’s huge debts, we can expect currency debasement and eventually higher rates of inflation to reduce the real value America’s debts at home and abroad.

We have never in the economic history of the United States seen a period of rapid growth in money and credit nor an extended period of negative real interest rates that has not been followed by a declining dollar exchange rate abroad and a rising inflation rate at home.

A number of important foreign central banks - most notably the People’s Bank of China and the Reserve Bank of India - are waking up to this situation.

They are seeking ways to diversify their reserve assets in order to minimize dollar-related risks - and this includes acquiring proportionately more euro-denominated debt and more gold purchases by the official sector.

With this macroeconomic situation in mind, let’s take a quick look at five important gold-market developments: (1) the continuing slide in world gold mine production, (2) the surge in old gold scrap last year and early this year, (3) the fall of jewelry fabrication demand, (4) changing central bank attitudes with respect to gold, and (5) important developments in the gold investment arena.

Declining Mine Production

Annual worldwide gold-mine production peaked in 2001 at 2,645 tons and has been falling gradually ever since.  Despite a brief uptick in global gold production this year, the long-term downtrend is expected to continue at least another few years . . . and by 2011 output will likely have dwindled to less than 2,300 tons - a decline of 14 percent over the 10-year period.

Over the long term, mine output is a reflection of price versus the rapidly rising cost of production and the increasing difficulty and expense in finding new deposits large enough to offset the loss of production from the ongoing depletion of existing mines.

In addition, increasingly stringent environmental regulations are adding to costs - and unfriendly government attitudes toward mining or foreign ownership in some countries - are discouraging exploration and development.

Importantly, the continuing global economic crisis has slowed funding and retarded mine exploration and development in many countries, particularly for exploration and junior mining companies.

One explanation to the on-going decline in worldwide mine production is that prices in the past couple of decades simply have not been high enough to encourage exploration and development sufficient to replace the dwindling reserves in the historic “big four” gold producing countries - South Africa, the United States, Canada, and Australia.

Interestingly, the locus of world gold-mine production is shifting from the previous “big four” to the emerging market nations - particularly China and Russia - both of which seem likely to hoard or consume most, if not all, of their gold-mine production, rather than sell it into the world market.

China became the world’s number one gold-producing country in 2007 aided by supportive government policies that continue to promote a rapid pace of mine development and rationalization of the industry.  As you know better than I, these policies are likely to continue . . . and China’s gold-mine production should continue to grow, both in absolute terms and as a proportion of total world output.

Although there is much exploration and development activity in a number of prospective regions around the world - and more can be expected as prices rise and access to financing improves - it will not be sufficient to reverse the downtrend in global gold-mine production for at least the next five years - and likely longer.

Even if the price of gold rises substantially in the next few years sufficient to provoke a rush of exploration and mine development, for projects large enough to make a big difference, it usually takes five to ten years or longer to move from exploration to development and then to large-scale production.

Secondary Supply

Unlike “primary” output from mines, the recycling of old scrap - mostly from jewelry - sometimes reacts quickly to changes in the price of gold beyond certain levels that are seen by holders as attractive “selling” points.

Last year and earlier this year, as prices rose through the $900 and $1000 an ounce levels, holders of old gold jewelry in many countries made a collective judgment that the price was too high.  As a result, scrap supplies exploded, so much so that there was a flood of metal into the market, making the higher price levels unsustainable.

Scrap recycling, which on average had been running about a thousand tons a year climbed to double that rate in the fourth quarter of 2008 and the first quarter of 2009.

In the past couple of years, the rise in jewelry scrap has also been a reflection of economic hardship, high unemployment, and a desperate need for cash by some holders of old gold jewelry.

But this year, with prices over $1000, there has been a sea change in scrap flows.  Apparently holders of old gold items began to think of $1000 an ounce as the new floor rather than the old ceiling.  And it hasn’t been until quite recently, with gold well over $1,100 an ounce that scrap supplies have picked up - but secondary supply still remains well below the pace of a year ago.

Falling Jewelry

Let’s turn from old scrap - where old jewelry is a source of supply - to new jewelry fabrication, which until recent years has been a steady and reliable source of gold demand.

Gold jewelry fabrication demand reached an all-time in 1997 at 3,342 tons - and, since then, has been trending downward.  Last year, global jewelry fabrication demand fell below 2000 tons . . . and this year, it could amount to less than 1,900 tons worldwide.

Much of the decline in jewelry offtake has occurred since 2001 and reflects the substantial rise in gold prices - both in U.S. dollar terms and in local currencies for many important geographic jewelry markets.

In more recent years, the poor economic environment has also hit jewelry demand, especially in the United States and Europe.  In addition, and of importance to the near-term outlook, the steep decline in fabrication had been exaggerated by a reduction of inventories on hand at manufacturers, distributors, and retailers.

In general, I expect a modest recovery in worldwide jewelry demand, reflecting an improving economic environment in some of the developing markets - especially India and China - and supported also by some rebuilding of inventories . . . but this recovery will muted by the expected rise in the metal’s price over the next few years and by an on-going shift to lighter and lower karatage items in some markets.

While changes in gold’s commodity fundamentals are important, it is developments in the official sector and private investment arena that will have the greatest impact on the metal’s future price.

Official Sector Gold Policies

So, let’s turn our attention to the official sector - where momentous changes are underway.

I believe this past year will prove to be a key turning point in the modern history of gold as an official reserve asset.  Central bank attitudes with respect to gold are becoming increasingly positive.  After years of persistent net sales by central banks in the aggregate, the official sector has this year become a net purchaser of gold from the market.

On average, the central banks of the world hold about 10 percent of their international reserves in gold . . . but there is great disparity from country to country and region to region.

The major Euro-zone nations together hold about 55 percent of their assets in gold.  In contrast, the Asian nations, as a group, hold only about two percent of their reserves in gold.  Based on recent published statistics, China has about two percent of its reserve assets in gold and Russia now holds about six percent in gold.

Over the past three decades, beginning in the mid-1970s, gold has been under the threat of massive sales by the world’s gold-rich central banks and by the International Monetary Fund as well.  In fact, up to now, the official sector has been a net seller of gold each and every year since 1989.

Over the past 20 years, net sales by the official sector have averaged over 400 tons a year, accounting for about 12 percent of total supply over the period.  One can imagine that this additional supply of gold entering the market year after year must have had a considerable negative influence on the metal’s price.

Most of this metal came from a number of European central banks, some of whom simply thought they were over-weighted in gold relative to interest-bearing U.S. dollar securities . . . and some who saw gold as a “barbaric relic” to be disposed of in favor of modern financial instruments.

Large-scale European central bank gold sales now appear to have run their course.  In part, this reflects a renewed respect for gold as a reserve asset and reliable store for value - and a loss of respect for the U.S dollar alternatives.

In hindsight, central banks that sold large quantities of gold in the past now look quite foolish.  In addition, many central bankers are bullish on the metal and don’t want to sell an appreciating asset.

For sure, official sales - and the threat of more to come - have often contributed to negative sentiment in the marketplace with the price typically falling whenever one or another central bank announced a sales program.

But now, the opposite is true.  Western central bank sales have run their course - and Eastern central banks, exemplified by China and India, with relatively low gold holdings appear eager to acquire more.

The expectation of central bank purchases is bolstering the market.  Each announcement by one or another central bank - even a tiny country like Mauritius - encourages private investors and has been greeted with an advance in the metal’s price.

Why Central Banks Hold Gold

So why do central banks hold gold . . . and why are some now buying more?

• First, gold brings a degree of economic security. It is the only monetary or financial asset (apart from silver) that is not another’s liability and, therefore, makes it free from counterparty risk. It cannot be undermined or devalued by inflation in a reserve currency nation, nor can it be repudiated or defaulted upon for any reason by another country or institution.
• Second, gold provides protection against unexpected events. It provides “catastrophe insurance” in case of war, high (or hyper-) inflation, or internal political upheaval - because it is always liquid and universally accepted as a means of payment.
• Third, gold creates confidence. Although no currency in circulation today is backed by or convertible into gold, central bank gold holdings may instill a degree of confidence in a country’s currency.
• Fourth, gold serves as a great diversifier. Just as private investors may own gold as a portfolio diversifier, so do central banks. Since the metal’s price tends to be uncorrelated - or sometimes inversely correlated - with a central bank’s foreign currency holdings, inclusion of gold tends to reduce the volatility of a nation’s reserve assets.
• Fifth, gold offers physical security. Where appropriately located, gold cannot become subject to exchange controls or seizure by a hostile government.
• Sixth, gold may lend prestige. A significant gold position - or a significant addition to a country’s gold reserves - may bring with it a degree of international prestige and recognition in the family of nations. (For example, India’s recent acquisition made a powerful statement to the world that they are no longer a third-world economy but a leading nation in the world economy.)
• Seventh, some countries with domestic gold mine production, large current account surpluses, and growing foreign currency reserves might prefer to purchase its own domestic output, paying producers in its own currency, rather than sell its production into the world market for yet more unwanted foreign currency reserves.
• Eighth, geopolitical posturing: It is quite likely that central bankers here in China as well as in Russia have increased their official gold reserves, rather than accumulate still-more dollars, as a tacit declaration of economic independence, and as a warning that they are no longer playing by the old rules favoring the United States.

Who’s Buying

The International Monetary Fund has also made news, moving forward with its plans to sell 403.3 tons of gold to restore its own financial position and support lending to the poorest countries.

IMF strategists had suggested that sales might occur gradually over two or three years - so they must have been taken aback by India’s purchase of 200 tons.  Mauritius was next, buying two tons from the IMF and then Sri Lanka’s bought 10 tons from the IMF, this on top of another 5.3 tons purchased earlier in the year in the world market.

Most observers believe the remaining balance - 191.3 tons - will be sold “off the market” directly to central banks wishing to augment their official gold holdings.  Some think China will be the next big buyer but India is rumored to want more and other countries -Russia, Brazil, and the Gulf states - are also mentioned as possible buyers.

To a large extent, gold sales by the IMF had been already anticipated and factored into the current price.  However, direct sales - off the market - are providing confirmation that central bank attitudes are shifting in favor of gold and each announcement has had a strong positive affect on private investor interest and, consequently, on the metal’s price.

Other big news of the past year has been announcements from both China and Russia that they have been buying gold from their domestic mine production - importantly demonstrating that some large central banks can gradually buy gold without disrupting the market.

Some of you who attended this conference last year may recall my advice to the People’s Bank of China to buy gold from domestic gold mine production.  This past April, it was revealed that they had been doing so since 2003, buying 454 tons, bringing its total official holdings to 1,054 tons - still less than two percent of its total official reserves.

I believe China continues to buy gold from domestic production at a rate of maybe 75 tons a year - but China’s official gold purchases this year have not yet been transferred to the central bank accounts and have not yet been reported as official reserves.

Russia, like China, has also been buying gold for official reserves from its own domestic mine production.  Prime Minister Putin has said that Russia should hold 10 percent of its official reserves in gold.  Its central bank has revealed the purchase of 15.6 tons in October, bringing its total holdings to just over 606 tons - about 4.7 percent of total reserves.  We can anticipate continued purchases as Russia strives to reach its 10 percent target.

A number of countries are calling for a new international reserve asset based on a basket of currencies with an enhanced role for gold.  This seems highly unlikely anytime soon - but as long as it is being discussed and remains even a distant possibility, central banks are more likely to hoard their existing gold stocks . . . and some countries with uncomfortably large dollar-denominated holdings will probably buy more, either from their own domestic production or, when conditions allow, in the open market.

The Expansion of Investment

Investor interest in gold is also changing in a number of important ways with potential price implications that are not fully appreciated or recognized.  Developments in key geographic markets along with new investment vehicles are making gold more accessible and more mainstream to more investors around the world - and the result is a permanent upward shift in the demand curve so that much higher prices will be the norm rather than a temporary cyclical episode.

Already, the introduction and growing popularity of gold exchange-traded funds (ETFs) are having a profound influence on the gold market.

Gold ETFs are gold-backed stock-market securities representing ownership in a trust designed to track the ups and downs of the metal’s price.

Importantly, gold ETFs are bought, sold, and trade just like equities on a stock exchange - and they avoid the tax, storage, and other difficulties sometimes associated with owning physical gold in some national markets.

Gold bars and coins have long been considered an unconventional investment choice by most Americans - but gold ETFs are now becoming a very conventional choice for many investors worried about the long-term value of the dollar, the overvaluation of equities, and the prospects for future inflation.

By facilitating gold investment and ownership they have brought significant numbers of new participants to the market - not just individuals but hedge funds, pension funds, and other institutional investors some of whom are prohibited from investing in physical commodities or futures contracts but can and are investing in gold ETFs.

Today, gold held in depositories on behalf of ETF investors totals close to 1,750 tons, more than the central banks of either Switzerland or China - a remarkable feat considering gold ETFs have been around only about six years and got off to a slow start.

I’ve already mentioned China’s central bank interest in gold.  As many of you know much better than I, the Chinese government has recently gone one step further by encouraging private citizens to buy and hold gold - and gold investment bars, bullion coins, and other gold-backed vehicles are now available through the domestic banking system as well as at many jewelry retailers and department stores.

I’m told that investor participation in gold is expanding, prompted in part by booming real estate and equity markets and by rising inflation expectations.  Future announcements of central bank additions to the country’s official gold reserves will probably encourage more private buying as well.  Given the vast number of potential buyers along with the expected growth in personal income and wealth, I believe Chinese gold demand has the potential to push prices much higher in the next few years.

With some gradual appreciation of the yuan against the U.S. dollar in the years ahead, the local-currency price of gold may not rise quite as dramatically as the U.S. dollar denominated price - but gold’s future appreciation will still be quite satisfying to Chinese investors and long-term savers.

The Future Price of Gold

The future price of gold - at least over the long term - has less to do with mine production, secondary supply, jewelry fabrication or any of the other “commodity” fundamentals of gold supply and demand . . . and most to do with gold’s appeal as a financial and monetary asset - an asset held as a savings medium, store of value, portfolio diversifier, and insurance policy by individuals, investment institutions, and central banks alike.

As I discussed earlier, real interest rates are a reliable indicator of Federal Reserve monetary policy - and it is monetary policy and money-supply growth that ultimately affects the dollar, inflation, and the U.S. dollar denominated gold.

The historical data show that the U.S. dollar gold price is inversely related to the real (or inflation adjusted) rate of return on U.S. Treasury securities.

Not surprisingly, the current bull market for gold that began in 2001 (with gold near $255 an ounce) has, for the most part, been a period of negative or low real interest rates.

In fact, in the years of market-determined gold prices (since August 1971 when President Nixon closed the gold window) each and every time the real inflation-adjusted three-month U.S. Treasury bill rate fell below zero, the U.S. dollar gold price rose over the subsequent 12-month period.

The great bull market for gold in the late 1970s culminating in the 1980 high near $875 an ounce was a period of negative real interest rates in the United States.  Similarly, the stunning gold-price rallies in late 2007 and early 2008 - and again this year - were preceded by periods of negative real interest rates.

Today, real “inflation-adjusted” interest rates on short-term Treasury bills are even more negative . . . so, if history is a guide, we can expect the price of gold to continue moving higher over the next year.

No Bubble for Gold

There has been much talk lately about asset bubbles in various markets caused by traders and fund managers borrowing U.S. dollars at low interest rates to invest in what they expect will be higher yielding equity, real estate, and commodity markets around the world.  This inflation in some asset markets far above their fundamental values is complicating economic policy in many countries.  History suggests that buying mania - whether Dutch tulips, U.S. equities, or real estate here in Shanghai - inevitably end leaving much economic carnage in their wake.

Although gold is surely benefitting - along with other markets - from speculation with cheap money, the surging gold price is anything but a bubble.  It’s built on the same monetary fundamentals and other factors that have supported a rising gold price in the past - easy money, low real interest rates, unbridled growth in U.S. Federal debt, diminishing faith in the U.S. dollar, rising geopolitical tensions, and global economic policy discord.

As my clients know, I am “extremely optimistic” on the gold-price outlook - but, unlike many other bullish analysts, I believe the metal’s ascent will take several years to reach its next long-term cyclical peak.

In the meantime - partly because of the activity of ETF investors, partly because the price sensitivity of secondary supply and jewelry fabrication in this difficult economic environment, and partly because steep declines in other markets may briefly pull gold lower - we can expect high volatility and, at times, a difficult climb, with sharp reversals along the way that will may cause some observers to wonder if the market has already topped out.

Ultimately, thanks to the extremely expansionary U.S. monetary policy - and with help from ETF investors, central banks, and new or evolving geographic markets - like China and India - I believe gold could climb into the US$2,000 to $3,000 range in the next few years - and possibly much higher if a serious crisis of confidence triggers a massive flight from the U.S. dollar.

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Hong Kong Speech: Gold Market Situation & Outlook

Speech to the Gold Outlook Asia 2009 Conference
Hong Kong – October 22, 2009

I’ve been asked to talk about the world economic and financial crisis – and the implications for gold. In addition, I want to discuss important changes in the official sector and structural developments in the private investment sphere that have important implications for the price of gold over the next few years.

The place to begin, however, is with the U.S. and global macroeconomic situation – past, present, and future.

This is an especially appropriate topic for an American economist since it has been, in large measure, America’s economic policies over the past several decades that have landed us in today’s international economic predicament.

Easy Money

In my view, the root cause of the current world economic crisis has been decades of easy money, low interest rates, and a persistently expansionary monetary and fiscal policy by the United States – aided and abetted by China and the other major Asian exporting nations. As a result, Americans have been on a buying binge in the global marketplace, buying things we often don’t really need with money we don’t really have.

And the rest of the world – especially China and the other Asian economic powerhouses – have been co-conspirators, lending us the money to satisfy our need for more things in order to promote economic growth and high employment in their own economies.

Now, however, many foreign lenders – both private and official – who have been financing America’s budget and trade deficits are becoming increasingly uncomfortable pouring more and more good money after bad.

Here’s a quick lesson about the economic history of the late 20^th and the early 21^st centuries: Beginning in President Reagan’s second term with the appointment of Alan Greenspan as Chairman of the U.S. Federal Reserve and continuing with Ben Bernanke at the helm of America’s central bank, the Fed has pursued an expansionary, low interest-rate policy that has placed growth above all else.

During these years, every economic or financial-market crisis was met with injections of liquidity into the banks and financial markets with interest rate cuts often to negative inflation-adjusted rates of return.

The stock market crash of 1987, the Gulf War beginning in 1990, the Mexican Peso Crisis in 1994, the Asian Currency Crisis in 1997, the Long-Term Capital Management bankruptcy in 1998, the Internet Dot-Com Bubble in 2000, and the U.S. Housing Bubble that ended in 2007:

Each crisis was met with more money and lower interest rates – a policy that came to be known as the “Greenspan Put” and more recently the “Bernanke Put” because it assured many of the most reckless risk-takers they would not lose a red cent. Even if their investment and trading strategies went awry, the Fed was there to bail them out.

We never would have had the last stock market boom carry valuations to such heights without easy money.

We never would have had the U.S. housing boom without artificially low interest rates and without Fannie Mae and Freddie Mac promoting home ownership for everyone.

We never would have had the mortgage-backed securities debacle without easy money and low interest rates. And, no one – especially foreign central banks – would have bought these and other sub-prime securities if they thought they could lose their shirts.

A healthy vibrant economy needs to clean out the dead wood from time to time. Rather than allowing periodic recessions and bear markets to purge the excesses of each prior boom or bubble, the Fed stimulated the economy with massive doses of new credit, more liquidity, and lower interest rates. Neither the Fed nor the politicians in Washington wanted a recession – and hardly anyone complained when the Fed just printed more money.

Not Over Yet

Today, we should not be fooled by signs the U.S. financial crisis is now over. The losses are still there . . . and still growing: They’ve only been transferred from Wall Street and the private sector to the Federal Reserve and the U.S. Treasury.

And, don’t be fooled that the recession in the United States is really over and things are getting back to normal. The U.S. economy is showing signs of life only because of massive injections of liquidity from the Fed, unprecedented fiscal stimulus by the U.S. Treasury, and inventory restocking.

Do you really think the economy will continue to grow if the Fed removes the intravenous feeding tube? Do you really think American consumers are in shape to start spending again – with unemployment rising, household wealth diminishing, and continuing uncertainty about our economic future?

Although many economists, politicians, investors, and news reporters are beginning to talk about economic recovery in the United States, those that are seeing “green shoots” in my view are looking through “rose-colored” eyeglasses . . . and there is significant risk of a “double-dip” recession with further contraction and a second down-leg in U.S. equity prices yet to come.

Indeed, much of the recent uptick in economic activity reflects the government stimulus programs, such as the “cash-for-clunkers” program that gave the U.S. auto industry a temporary boost.

While some of these programs help businesses and households in the short run, they are all adding to the Federal budget deficit . . . and, in the long run, will complicate the Federal Reserve’s monetary policy dilemma.

We are in this mess today because America borrowed and spent too much, because we created too much credit, pumped out too much liquidity, and often kept interest rates too low– and the rest of the world was willing to go along.

Now, the politicians and policy-makers are telling us the cure is more spending, more borrowing, bigger deficits, more credit, more liquidity and negative real interest rates.

How can this be? It was too much liquidity, too much credit, too much spending, and too much borrowing that created the economic crisis in the first place.

Yet, Americans are told by mainstream economists and politicians that the prescription is more of the same – only in bigger doses.

Just look at the surging Federal budget deficit: Not many years ago, a deficit of two hundred or three hundred billion dollars was considered sufficient to elicit concern. Now, we expect annual deficits in the trillions for at least the next 10 years . . . and few are complaining.

I don’t know what the prescription is . . . but I can tell you it’s not more of the same. Would you tell a drug addict to cure his addiction with more heroin, only in bigger doses? Of course not!!

However, what I do know is that difficult times lie ahead – not just for the United States but also for many of its creditors and trading partners. Large budget deficits call for increased taxation at home – but tax increases are an anathema to Americans and there is only so much American voters will accept.

Inflation Ahead

In lieu of actually paying down America’s huge debts, we can expect currency debasement and higher rates of inflation to reduce the real value America’s debts at home and abroad.

Here’s another indicator that the United States is headed into a period of higher inflation.

We have never in the economic history of the United States seen a period of rapid growth in money and credit nor an extended period of negative real interest rates that has not been followed by a declining dollar exchange rate abroad and a rising inflation rate at home.

A number of important foreign central banks – especially China and the other Asian tigers – are waking up to this situation.

They are seeking ways to diversify their reserve assets in order to minimize dollar-related risks – and this will likely include acquiring proportionately more euro-denominated debt and more gold purchases by the official sector.

And, they will increasingly encourage their corporate sectors to invest in real assets around the world – including mining and mineral resources – so that they get something of intrinsic value for some of those depreciating dollars held by their central banks.

With higher inflation and a depreciating U.S. dollar, I think you can sense that I’m bullish on gold. I’ll have more to say about this later.

But first I’d like to briefly discuss five important gold-market trends: (1) the continuing slide in world gold mine production, (2) the surge in old gold scrap last year and early this year, (3) the fall of jewelry fabrication demand, (4) changing central bank attitudes with respect to gold, and (5) important developments in the gold investment arena.

Mine Production in Decline

Annual worldwide gold-mine production peaked in 2001 at 2,645 tons and has been falling gradually ever since. This downtrend is expected to continue at least for the next few years . . . and by 2011 it will likely have dwindled to less than 2,300 tons – a decline of 14 percent over the 10-year period.

Over the long term, mine output is a reflection of price versus the rapidly rising cost of production and the increasing difficulty and expense in finding new deposits large enough to offset the loss of production from the ongoing depletion of existing mines.

In addition, increasingly stringent environmental regulations are adding to costs – and unfriendly government attitudes toward mining or foreign ownership in some countries – are discouraging exploration and development.

Importantly, the stock-market crash and continuing global economic crisis has slowed funding and retarded mine exploration and development in many countries.

One explanation to the on-going decline in worldwide mine production is that prices in the past couple of decades simply have not been high enough to encourage exploration and development sufficient to replace the dwindling reserves in the historic “big four” gold producing countries – South Africa, the United States, Canada, and Australia.

Interestingly, the locus of world gold-mine production is shifting from the “big four” to the emerging market nations – particularly China, Russia, Indonesia, and Peru.

China became the world’s number one gold-producing country in 2007 aided by supportive government policies that continue to promote a rapid pace of mine development and rationalization of the industry. These policies are likely to continue . . . and, I expect, China’s gold mine production will continue to grow, both in absolute terms and as a proportion of total world output.

Although there is much exploration and development activity in a number of prospective regions around the world – and more can be expected as prices rise and access to financing improves – it will not be sufficient to reverse the downtrend in global gold-mine production for at least the next five years – and likely longer.

Even if the price of gold rises substantially in the next few years sufficient to provoke a rush of exploration and mine development, for projects large enough to make a big difference, it usually takes five to ten years or longer to move from exploration to development and then to large-scale production.

The Rise of Secondary Supply

Unlike “primary” output from mines, the recycling of old scrap – mostly from jewelry – reacts quickly to changes in the price of gold beyond certain levels that are seen by holders as attractive “selling” points.

Last year and earlier this year, as prices rose through the $900 and $1000 an ounce levels, holders of old gold jewelry in many countries around the world made a collective judgment that the price was too high. As a result, scrap supplies exploded, so much so that there was a flood of metal into the market, making the higher price levels unsustainable.

Scrap recycling, which on average runs about a thousand tons a year climbed to double that rate in the fourth quarter of 2008 and the first quarter of 2009.

In the past couple of years, the rise in jewelry scrap has also been a reflection of economic hardship, high unemployment, and a desperate need for cash by some holders of old gold jewelry.

With prices recently over $1000, it is encouraging to note that the responsiveness of scrap has been much more subdued compared to the previous episodes of gold moving over this psychologically important price level.

The Fall of Jewelry

Let’s turn from old scrap – where jewelry is a source of supply – to jewelry fabrication, which until recent years has been a steady and reliable source of gold demand.

Gold jewelry fabrication demand reached an all-time in 1997 at 3,342 tons – and, since then, has been trending downward. This year, I expect worldwide jewelry fabrication demand will total little more than 2,100 tons.

Much of the decline in jewelry offtake has occurred since 2001 and reflects the substantial rise in gold prices – both in U.S. dollar terms and in local currencies for many important geographic jewelry markets.

With the continuing credit crisis and global recession, demand has also been hit hard by the collapse in retail sales, especially in the United States and Europe. In addition, and of importance to the near-term outlook, the steep decline in fabrication has been exaggerated by the running down of inventories on hand at manufacturers, distributors, and retailers.

In general, I expect a modest recovery in worldwide jewelry demand, reflecting an improving economic environment in some of the developing markets – especially India and China – and supported also by some rebuilding of inventories . . . but this recovery will muted by the expected rise in the metal’s price over the next few years.

Official Sector Gold Policy

Let’s turn our attention to the official sector. As many of you know, central banks and the IMF have been are a hot topic in the world of gold.

I believe this year is a key turning point in the modern history of gold as an official reserve asset. Central bank attitudes with respect to gold are becoming increasingly positive. After years of persistent net sales by central banks in the aggregate, the official sector is now becoming a net purchaser of gold from the market.

On average, the central banks of the world hold about 10 percent of their international reserves in gold . . . but there is great disparity from country to country and region to region.

The major Euro-zone nations together hold about 55 percent of their assets in gold. In contrast, the Asian nations, as a group, hold only about two percent of their reserves in gold. Based on recent published statistics, China has about 1.9 percent of its reserve assets in gold and Russia holds about 4.3 percent in gold.

For the past three decades, beginning in the mid-1970s, gold has been under the threat of massive sales by the world’s gold-rich central banks and by the International Monetary Fund as well. In fact, the official sector has been a net seller of gold each and every year since 1989.

At times, official sales – and the threat of more to come – have contributed to negative sentiment in the marketplace with the price typically falling whenever one or another central bank announced a sales program.

This was seen most dramatically in 1999 when, much to its recent embarrassment, the Bank of England sold over half its official gold reserves at an average price of about $275 an ounce. So much for central bankers making smart decisions!!

A number of other European central banks – among them Switzerland, France, Italy, Spain, Portugal, and the Netherlands – followed Britain, together selling about 3900 tons in total over the next 10 years.

Realizing that their gold sales were having a considerable disruptive affect on the market and the metal’s price, the European central banks announced in September 1999 their agreement to limit future gold sales to no more than 400 tons per year over the next five-year period.

This was followed by a second Gold Agreement in 2004, which limited sales by the European signatory nations to 500 tons per year for another five years.

And, just recently, the European Central Bank announced a third Agreement that caps the group’s aggregate sales once again to 400 tons per year for the next five years.

All of this may prove to be irrelevant because the European central banks have not been inclined to sell much gold this past year – and my guess is that they will not sell much at all during the next few years.

For one thing, many central bankers are bullish on the metal and don’t want to sell an appreciating asset.

Moreover, central banks that have sold large quantities of gold in the past now look quite foolish as the metal’s price has moved higher and the value of their U.S. dollar reserves has declined.

European central bank sales in this final year of the second Central Bank Gold Agreement, which ended last week, will probably total about 150 tons versus the 500 tons allowed.

I believe the decline in gold sales by the European central banks reflects a renewed respect for the yellow metal as a reserve asset and reliable store of value.

The International Monetary Fund has also made news with its plans to sell 403.3 tons of gold to support lending to the poorest countries. IMF strategists have suggested sales might occur gradually over two or three years. Others believe all 403 tons may be sold “off the market” directly to one or a few central banks – with China, Russia, India, Brazil, and the Gulf states mentioned as possible buyers.

Importantly, the new Central Bank Gold Agreement incorporates these sales by the IMF, even though the Fund is not a signatory. In other words, total sales by the European central banks and the IMF cannot exceed 400 tons per year – unless some of the IMF metal is transferred “off the market” to one or more central banks.

To a large extent, gold sales by the IMF are already anticipated and factored into the current price. However, direct sales – off the market – to one or more central banks would be confirmation that central bank attitudes are shifting in favor of gold and would likely have a positive affect on the metal’s price.

The big news of the past year has been announcements from both China and Russia that they have been buying gold from their domestic mine production – importantly demonstrating that large central banks can gradually buy gold without disrupting the market.

This past April, China told the world it had purchased 454 tons since 2003, bringing its total official holdings to 1,054 tons – still less than two percent of its total official reserves.

I believe China continues to buy gold from domestic production at a rate of at least 75 tons a year – but gold purchases this year have not yet been transferred to the central bank accounts and have not yet been reported as official reserves.

Russia, like China, has also been buying gold for official reserves from its own domestic mine production. Prime Minister Putin has said that Russia should hold 10 percent of its official reserves in gold versus the 4.3 percent that it held at the end of July. Recent statistics indicate the country has added nearly 50 tons to its official reserves during the first seven months of the year.

The Expansion of Investment

While changes in gold’s commodity fundamentals are important, it is developments in the investment arena that will have the greatest impact on the metal’s price.

Already, the introduction and growing popularity of gold exchange-traded funds (ETFs) is having a profound influence on the gold market.

Gold ETFs are gold-backed stock-market securities representing ownership in a trust designed to track the ups and downs of the metal’s price. Despite some rumors to the contrary, certainly the major gold ETFs representing the lion’s share of the market are backed 100 percent by physical bullion held in depositories on behalf of ETF investors.

Importantly, gold ETFs are bought, sold, and trade just like equities on a stock exchange – and they avoid the tax, storage, and other difficulties sometimes associated with owning physical gold.

By facilitating gold investment and ownership they have brought significant numbers of new participants to the market – not just individuals but hedge funds, pension funds, and other institutional investors.

So much so that bullion held in depositories on behalf of ETF investors now total some 1,729 tons, more than the central banks of either Switzerland or China – a remarkable feat considering gold ETFs have been around only about six years and got off to a slow start.

I’ve already mentioned China’s central bank interest in gold. Just recently, China has gone one step further by encouraging private citizens to buy gold and silver investment – and will be making investment bars available through the domestic banking system.

To put this into perspective, imagine that just one percent of China’s population each buys one ounce of gold next year – that’s 13 million ounces (or about 404 tons) of new demand, coincidentally about the same amount the IMF will now be selling.

The Future Price of Gold

The future price of gold – at least over the long term – has less to do with mine production, secondary supply, jewelry fabrication or any of the other “commodity” fundamentals of gold supply and demand . . . and most to do with gold’s appeal as a financial and monetary asset – an asset held as a savings medium, store of value, portfolio diversifier, and insurance policy by individuals, investment institutions, and central banks alike.

As I discussed earlier, real interest rates are a reliable indicator of Federal Reserve monetary policy – and it is monetary policy and money-supply growth that ultimately affects the dollar, inflation, and gold.

The historical data show that the U.S. dollar gold price is inversely related to the real (or inflation adjusted) rate of return on U.S. Treasury securities.

Not surprisingly, the current bull market for gold that began in 2001 (with gold near $255 an ounce) has, for the most part, been a period of negative or low real interest rates.

In fact, in the years of market-determined gold prices (since August 1971 when President Nixon closed the gold window) each and every time the real inflation-adjusted three-month U.S. Treasury bill rate fell below zero, the U.S. dollar gold price rose over the subsequent 12-month period.

The great bull market for gold in the late 1970s culminating in the 1980 high near $875 an ounce was also a period of negative real interest rates in the United States. And, gold’s run up in late 2007 and early 2008 – an advance that saw the price rise briefly over $1,030 an ounce – was again a period of negative real interest rates.

Today, real “inflation-adjusted” interest rates across a range of maturities are again negative . . . so, if history is a guide, we can expect the price of gold to continue moving higher over the next year.

As my clients know, I am “extremely optimistic” on the gold-price outlook — but, unlike many other bullish analysts, I believe the metal’s ascent will take several years to reach its next long-term cyclical peak.

In the meantime – partly because of the activity of ETF investors and partly because the price sensitivity of secondary supply and jewelry fabrication in this difficult economic environment – we can expect high volatility and a difficult climb, with sharp reversals along the way that will, at times, cause some observers to wonder if the market has already topped out.

Ultimately, thanks to the extremely expansionary monetary policy – and with a little help from ETF investors, central banks, and new or evolving geographic markets – like China and India – gold will most likely climb into the US$2000 to $3000 range – and it could go even higher given the right confluence of economic and political developments . . . or if a late-cycle mania produces a final hyperbolic bubble before the gold-price cycle moves into its next bear-market phase.

Filed under: Reports, Speech | American Precious Metals Advisors, bullion coins, central banks, China, economics, economy, ETFs, Exchange-Traded Funds, gold investment, gold mining, gold price, IMF, India, inflation, Jeffrey Nichols, mine production, monetary policy, money supply, Russia, scrap, Secondary Supply, U.S. dollar|No Comments

Buenos Aires Speech: Gold Market Situation & Outlook

Speech to the Latin Exploration 2009 Conference
Buenos Aires, Argentina - September 29^th, 2009

Jeffrey Nichols
Managing Director, American Precious Metals Advisors
Senior Economic Advisor, Rosland Capital

I’ve been asked to talk about the world economic and financial crisis - and the implications for gold.

This is an especially appropriate topic for an American economist since it has been, in large measure, America’s economic policies over the past several decades that have landed us in today’s international economic predicament.

The root cause of the current economic crisis has been decades of easy money, low interest rates, and a persistently expansionary monetary and fiscal policy by the United States.  As a result, Americans have been on a buying binge in the global marketplace, buying things we often don’t really need with money we don’t really have.

And the rest of the world - especially China and the other Asian economic powerhouses - have been co-conspirators, lending us the money to satisfy our need for more things in order to promote economic growth and high employment in their own economies.

The Jig is Up . . .

But like any Ponzi scheme, this greatest of all Ponzi schemes cannot go on forever.

Read the rest of this article »

Filed under: Speech | American Precious Metals Advisors, central banks, China, ETFs, Exchange-Traded Funds, gold, gold investment, IMF, inflation, Jeffrey Nichols, mine production, monetary policy, money supply, Russia, scrap, Secondary Supply, U.S. dollar|No Comments