World Economic Trends and the Future Price of Gold

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I recently had the pleasure and privilege of speaking again this year at the China Gold & Precious Metals Summit in Shanghai and to several private seminars organized by clients elsewhere across China.  Here’s the text of my presentation:

First My Forecast

Forecasters, whether of the economy, or the stock market, or the gold price are frequently wrong . . . but we are never in doubt.  It is up to you - the investor - to listen, evaluate, doubt, and make your own decisions about gold’s future price and the role the metal might play in your own investment portfolio and personal savings plan.

With this warning, let me tell you my own forecast:

I have no doubt that gold will move up sharply in the years ahead, reaching heights that might lead some to label me a “gold bug.”  I believe that the price of gold will, over the course of this decade, reach a multiple of recently prevailing prices.

Prices of $3000, $4000, and even $5000 an ounce are very likely during the course of this long-lasting bull market, a bull market that still has years of life left to it.

Not withstanding the recent sharp price decline, I’d be very surprised to see gold dip into “three-digit” territory - that is below $1000 an ounce - ever again.

But, gold prices will remain extremely volatile - with big swings both up and down along a rising trend.  In fact, big corrections - such as the decline from the September 6^th all-time record high near $1,924 an ounce to the recent low near $1,580 (a decline of nearly 20 percent) - will lead many investors, analysts, and pundits to declare the death of gold . . . or, at least, the death of the bull market we have enjoyed over the past dozen years.

Yet, historically, a gold-price decline of 20 percent is not so unusual.  At the time of the Lehman bankruptcy in 2008, gold fell by more than 20 percent and was slow to recover - but recover it did.  And, in the 1970s, gold corrected several times by 15 to 20 percent and once by considerably more - all in the midst of a great bull market.

Moreover, although the U.S. dollar-denominated price of gold is well off its historic high, when valued in most other currencies, the metal’s price remains near its record highs.

The future price of gold is a function of past and prospective world economic, demographic, and political developments.  My job for the next hour or so is to briefly review some of these developments and trends - so that you can come to your own “golden” conclusions.

Gold’s Bullish Building Blocks

Let me quickly list the gold’s bullish building blocks - and then, as time permits, I’ll discuss a few of these bullish factors, in somewhat more detail.  You will notice that many of these factors are interrelated - but it is easier, for the sake of this discussion, to think of them as separate and distinct.

• The first bullish building block is past and prospective U.S. Federal Reserve monetary policy, characterized by low or negative real rates of interest and unprecedented central bank monetary creation.

• Second, the U.S. federal government budget impasse, rising U.S. sovereign debt, and eroding U.S. creditworthiness.

• The third bullish building block for gold is the expected future depreciation of the U.S. dollar in world currency markets . . . and the continuing decline in the dollar’s purchasing power for American consumers.

• Fourth, the growing insolvency of some European nations - leading to the disintegration of Europe’s Monetary Union and the eventual abandonment of Europe’s common currency, the euro, by at least some of the EU member countries.

• Fifth, the expected acceleration of global inflation - fueled by excessive monetary creation, world population growth, and changing diets in favor of more meat and protein . . . and led by persistently high and rising agricultural and industrial commodity prices from one country to the next.

• The sixth bullish building block for gold is increasing political instability in the Middle East and North Africa . . . as authoritarian regimes are overthrown . . . but sectarian divisions in some countries prevent orderly transitions to democracy . . . with implications for world oil supplies and prices.  And then, of course, there is Iran - which remains an unpredictable “wild card.”

• Seventh, the growing affluence of the “emerging-economy nations” and the associated growth in both jewelry and private investment and savings demand for gold - especially here in China - as well as India and other gold-friendly countries.

• My eighth bullish building block - one that I believe is especially important to the long-term development of the gold market - is the affect this rising wealth is having on emerging-economy central banks . . . prompting some countries that are over-weighted in U.S. dollars and underweighted in gold to diversify their official reserves through the prudent acquisition of the yellow metal.

• Ninth, the development and popularity of new gold investment vehicles and channels of distribution - especially gold exchange-traded funds - that facilitate physical gold investment by both retail and institutional investors.

• Tenth, the legitimization of gold as an investment class and rising investor participation . . . together reflecting a growing appreciation of the benefits of including physical gold in a well-diversified portfolio . . . and the entry of new, large-scale, professional investors - including pensions, endowments, insurance companies, sovereign-wealth funds, and especially hedge funds.

• Eleventh, the “stickiness” of much of the recent private sector and central bank gold demand.  This is shrinking the available “free float” in the world gold market . . . and it means that less metal will be available to gold-hungry buyers, except at increasingly higher prices.  Indeed, many of today’s new investors have no intention of ever selling, even at much higher prices.

• And, twelfth in my catalog of bullish factors supporting a continuing long-term rise in the price of gold is the fact that world gold-mine production, although growing, will not keep pace with the expected growth in global gold demand.  Even a rash of new mine discoveries would take five to 10 years - or more - to contribute significantly to supply . . . and, meanwhile, existing resources are being depleted, nationalized by unfriendly governments who tend not to be good mine operators, or are simply mined out.

Together these dozen bullish building blocks have resulted in a notional gap between world supply and aggregate demand - a gap that has been and will be closed only by high and rising prices in the years ahead.

American Economics

Let’s look more closely at some of these bullish factors . . . and let’s begin at the epicenter of the world’s economic earthquake - Washington D.C.

The U.S. economy still faces significant and painful consequences from its many years profligacy, years in which both the government and private sectors simply spent more than we could afford, on things we didn’t need, and, worst of all, with money we didn’t have.  Now we are paying the piper - and it will be years before the massive overhang of public and private debt is no longer a heavy burden on the economy.

As a result, the U.S. economy is in the midst of a persistent and prolonged recession - a long-lasting slowdown that is not fully reflected in the official government statistics, not fully recognized by the most-widely quoted mainstream economists, and not likely to go away anytime soon.

Despite a recent pickup in consumer spending, improving employment indicators, and wishful thinking from the White House and many economic forecasters, the U.S. economy remains in the midst of a persistent and prolonged recession or worse.

Normally, a recessionary economy would be countered by aggressive short-term fiscal stimulus - with more government spending and less taxation  - to give a temporary counter-recessionary boost to aggregate demand.

But fiscal policy is moving in the opposite direction - and is likely to continue in the wrong direction, making a lasting economic revival even less likely anytime soon.

The U.S. federal government came close to shutting down a few months ago when it bumped up against its mandated borrowing limit.  It is likely that we will see a replay sometime next year as federal borrowing again nears the debt ceiling and as the 2012 federal budget debate demonstrates Washington’s inability to put partisanship aside and deal sensibly with the country’s economic problems.

America’s inability to get its fiscal house in order will, sooner or later, result in a resumption of the U.S. dollar’s long-term downtrend . . . and renewed appreciation of the dollar-denominated gold price.

With America’s fiscal policy in disarray, it will again fall upon monetary policy and the Federal Reserve to counter recessionary business conditions - especially persistently high unemployment - without aggravating inflation expectations.

So far, the Fed’s key inflation indicator - the so-called “core” inflation rate (which excludes food and energy, as if these items are not part of every family’s budget) - has been subdued by a weak economy.  But, sooner or later, just as night follows day, years of unprecedented U.S. and global money-supply growth, must result in higher prices and accelerating inflation.

But, no matter how hard it tries, the Fed can’t succeed on its own.  Without significant and meaningful U.S. fiscal reform - with believable long-term spending and revenue targets - the dollar’s role as the preeminent official reserve asset will likely continue to diminish.

Even without well-conceived long-term fiscal reform, the austerity demanded by domestic and world financial markets (what some have called the “bond-market vigilantes”) will come in dribs and drabs - a tax increase here, a spending cut there - but however it comes it will impose significant fiscal drag on an already teetering economy.

To counter a deteriorating economy and offset the negative effects of fiscal tightening, the Federal Reserve, for all its talk to the contrary, will be compelled to step even harder on the monetary accelerator, with another round of quantitative easing very likely early next year - with implications for future inflation, the U.S. dollar exchange rate, and the price of gold.

In my view, any further weakening of business conditions in the United States will prove to be very bullish news for gold.  This is because the Fed is much more likely to pursue an aggressive “easy-money” monetary policy - by printing more money, more quickly, and in bigger quantities - than would be the case in an economy already on the road to recovery.

Although they would never say so, the Federal Reserve and U.S. Treasury may be quite happy to see a weaker dollar and somewhat higher price inflation.

Why? Because a few years of higher inflation, an invisible tax, would reduce the real value of America’s debt as a percentage of nominal GDP, and bring this ratio (the debt-to-GDP ratio) back down to historically acceptable norms.  And, right or wrong, conventional economic theory says a weaker dollar would stimulate the U.S. economy through an improving trade balance.

Across the Atlantic - Breaking Up Is Hard To Do

Meanwhile, as U.S. policymakers fiddle, a number of European countries with their economic backs to the wall - including Greece, Ireland, Portugal, Spain, and most recently Italy - are slashing government spending and raising taxes at great social and political cost, hoping to avoid insolvency and default on their sovereign debt.

Unfortunately, as in the United States, the fiscal restraint demanded of these countries is the wrong medicine - and is more likely to kill the patient than cure the disease.

Despite the best of intentions, government revenues are falling as these countries fall deeper and deeper into recession.  Instead of increasing access to credit, the financial situation of these countries continues to deteriorate . . . and capital markets are demanding higher interest rates to refinance maturing sovereign debt - so much so that the costs are becoming unbearable and are putting these countries deeper in the hole.

As we are just now beginning to see, there is only so much “belt tightening” that electorates in these countries will accept.  Sooner or later, newly elected governments will likely reverse course, opting for less austerity in favor of more stimulative fiscal initiatives.

Europe’s deteriorating economic performance is already forcing the European Central Bank to pursue more accommodative monetary policies.

The widening disparity between the stronger “core” economies (led by Germany and France) and the weaker “periphery” countries will further threaten the viability of Europe’s common currency, the euro.  Safe-haven capital flight from the questionable euro into both the U.S. dollar and gold has, thus far favored the dollar - masking the greenback’s inherent weakness and, counter intuitively, contributed to the yellow metal’s retreat from its early September peak.

Any efforts to save the bankrupt periphery economies, as we have seen over and over again, will continue to be too little, too late . . . and, at best, will only postpone the ultimate day of reckoning.

What is missing is a shared sense of common statehood such as we enjoy in the United States.  Americans are, first and foremost, Americans - not New Yorkers, Floridians, or Californians.  But Germans are Germans and Greeks are Greeks.  They just don’t see themselves as Europeans first - and Germans just don’t see why they should work hard to bail out the Greeks or the Italians who, they say, don’t work hard enough, retire too early, and have it too easy.

Moreover, the disparity between inflation rates, economic productivity, and international competitiveness that separates the poorer periphery nations from the wealthier core economies is a gap that will prove too wide to bridge with a single currency.

Europe’s weaker economies are simply not competitive versus their stronger northern neighbors.  In the days before a single currency, countries could regain their competitiveness by depreciating their own currencies - but, with a single shared currency, this is no longer an option for individual members, each lacking their own currency and exchange?rate policy.

The only thing now holding the European single?currency monetary system together is the high cost of divorce - and the seeming impossibility of managing a break?up.

Even if the euro somehow survives, its role as a reserve asset has been badly damaged, further enhancing the appeal of gold to central bank reserve managers skeptical about accumulating more euro-denominated reserve assets.

A tarnished euro, periodic funding crises, and fears of a eurozone break?up will benefit gold in the months ahead - even if the lion’s share of scared money finds a safe haven and shelter from financial uncertainty in U.S Treasury securities and other dollar-denominated assets.

To sum up the economic situation:  I don’t think either the United States or European economies are heading toward total collapse.  Instead, we will muddle through with several years of sub-par economic activity, high unemployment, and rising inflation.

Chinese Liberalization Promotes Rising Demand

As a foreign visitor in China, I feel presumptuous talking to you about gold-market trends and developments in your own country.  But, no discussion of gold is complete without reporting on China’s importance and profound influence on the world market and the metal’s price.

As you know, private gold investment was banned and the local market was tightly controlled for more than five decades following the Communist Party victory and ascension to power in 1949.  Ever since the legalization of private gold investment and the gradual liberalization of the market beginning in 2002, China’s appetite for gold has been growing by leaps and bounds.

Much of the growth in China’s gold demand over the past few years has been a result of the government’s liberalization of the domestic market, its encouragement of private gold investment, and the development of new investment vehicles and channels of distribution.

Rapid growth in household incomes, an expanding middle class, and rising wealth have also been important, contributing to the growth in gold demand for jewelry as well as for personal savings and investment.

In recent years, China’s central bank, the People’s Bank of China, has also been a significant buyer.  Two and a half years ago - in April 2009 - the PBOC revealed it had bought some 454 tons of gold over the preceding six years, an average of about 75 tons per year.

Since then there has been no hard evidence of additional buying . . . but my guess is that your central bank continues to buy regularly from domestic mine production and scrap refinery output - perhaps as much as 50 to 100 tons per year.  For its part, the PBOC not long ago said it will “seek diversification in the management of reserve assets,” possibly implying their intention to accumulate gold without actually saying so.

As a result of China’s sizable appetite for gold, it has become a powerful driving force in the world gold market - and its influence on the future price of gold is likely to continue, if not grow, in the next few years reflecting demographics, economic growth, rising personal incomes, episodes of worrisome inflation, the continuing development of the domestic gold-market infrastructure, and, importantly, central bank reserve diversification.

Indian Demand Heats Up

China isn’t the only giant shaking up the world of gold.  India’s appetite for gold has also been hot like curry, reflecting - as in China - growth in household incomes, an expanding middle class, increasing national wealth, and, lately, worrisome inflation trends.  .

India has historically been a very price-sensitive market for precious metals.  Typically, gold demand falls as prices rise . . . and, at higher prices, owners of gold have usually been quick to take profits, cashing in their bangles and chains, so much so that Indian gold scrap has, at times, been an important source of supply to the world market.

But, in contrast to the historical experience, we are seeing much less price sensitivity of demand as Indian consumers have adjusted rather quickly to record high gold prices.  Even with the rupee-denominated price at or near all-time highs, Indians still seem to be fairly eager buyers, suggesting a psychological re-evaluation of long-term gold-price prospects among Indian jewelry buyers and investors.

India and China are very important markets for gold, in part, reflecting their huge populations and growing wealth.  But there are many other countries across Asia and the Mideast that share a historical, cultural, and even religious affinity to gold as a traditional monetary medium for saving and investment.  And, like China and India, we have seen strong demand from both households and central banks in a number of these countries as well.

Longer term, as many of these countries prosper and as their share of global income and wealth continues to increase, they will demand a growing share of the world’s above-ground stock of gold for jewelry, for investment, and for additions to central bank reserves.

Importantly, much of the gold bought by these countries will probably never come back to the world market, at least not for many years to come and only at much higher price levels or if political and economic developments prompt distress sales, something we will not likely see in the next few years.

Central Banks Buying More

For now, the U.S. dollar remains the number one world trade and official reserve currency by default.  There is simply nothing ready to take its place - certainly not Europe’s single currency, the euro.  That said, a recent survey of central-bank reserve managers predicted that the most significant change in their official reserve holdings in the next 10 years will be their intentional build up in gold.

I believe we are moving gradually toward a multi-currency system where an array of national currencies (including the Chinese yuan) - possibly along with IMF Special Drawing Rights and even gold - will together function as official reserve assets and settlement currencies with much less dependence upon the U.S. dollar.

Many central banks have taken a much more positive view of gold in recent years.   Indeed, the official sector has been a positive net buyer of gold for the past two or three years.  This follows some two decades in which the official sector was a net seller of gold to the market, reflecting mostly large-scale sales by European central banks that mistakenly thought gold was in descent as a legitimate reserve asset and sold at a mere fraction of today’s price.

Just looking at the recent official data actually reported by central banks and published by the International Monetary Fund, the official sector bought 148.4 tons, net of sales, in the third quarter alone . . . and, based on year-to-date data, it looks like net official purchases may total 450 to 500 tons - or more if we include a guess of unreported purchases by China and possibly others, including purchases by sovereign wealth funds that may be buying surreptitiously on behalf of their country’s central banks.

Following many years of net annual sales in the 400 to 500 ton range, the official sector became a net buyer of gold in 2009.  This is a “game changer” for the gold market.  Instead of supplying hundreds of tons, year in and year out, central banks are now buying at what seems to be a net rate of 400 to 500 tons per year - representing a swing in the annual supply/demand balance of 800 to 1000 tons a year.

I don’t think most market observers and participants fully appreciate just how significant this has been - and will continue to be - for the world gold market.

In addition to China, the list of countries that have bought gold in the past few years is itself growing with new, surprising names joining the club - names like:

?        Russia - which has been the most outspoken and one of biggest buyers of gold in recent years making monthly purchases from its domestic mining and scrap refining at a rate of about five tons a month . . . and has more than doubled its gold reserves over the past four years.

?        India - which made a strong pro-gold statement, buying 200 tons directly from the International Monetary Fund at the start of the IMF ’s gold-sales program a couple of years ago.

?        South Korea - which last summer announced the purchase of 25 tons, its first purchase since 1998 when it collected and resold gold jewelry donated by patriotic citizens to help the country through a period of economic emergency,

?        Saudi Arabia - also added significant quantities of gold - 180 tons, in fact - to its official holdings over the past few years - but did not report these purchases until last June.  It is likely that the Saudi Arabia Monetary Authority continues to buy on the sly . . . along with some of the other oil producers that, like the Saudis, are over-weighted in U.S. dollar assets and grossly underweighted in gold,

?        Thailand - which bought nearly 40 tons so far this year,

?        Mexico - has been the biggest buyer so far in 2011 at some 100 tons,

?        In addition to Mexico, other Latin American buyers include Bolivia (which recently bought seven tons following a similar purchase in December 2010), Colombia, and Venezuela (which not only bought some gold this year, but also repatriated much of its gold held abroad in Bank of England vaults),

?        Bangladesh and Mauritius - which also bought gold from the IMF gold sales program,

Meanwhile, gold sales by the European central banks have dwindled to practically nothing, only enough to supply their bullion and commemorative coin programs.

Keep in mind that aggregate central bank gold purchases probably exceed the official data by a wide margin.  The People’s Bank of China, the Saudi Arabian Monetary Authority, and other central banks with large U.S. dollar-denominated official reserve assets have an incentive to buy gold discretely and surreptitiously - simply because the announcement of their buying programs would likely boost the yellow metal’s price and raise these central bank’s acquisition costs.

As we saw in September, after prices took a tumble, official demand responded positively.  Central banks, in the aggregate, are bargain hunters, what we call “scale-down buyers.”

But the reverse is not true:  We don’t see central bank profit-taking when prices move sharply higher.

Importantly, much of the gold bought by central banks has been bought for the long term - and will likely be held not just for a few days or months or even a few years . . . but for decades or longer, even at much higher prices.

As a result, central banks are now creating an upside bias to the market and are reducing the “free-float” available to meet future demand, even at much higher prices.  As a consequence, we can expect less downside volatility - and a more sustainable bull market with much higher prices in the years to come.

Rising Participation

Even though more people than ever before are buying gold, participation by both retail and institutional investors in the United States and many other countries remains very low.  Moreover, many investors already holding gold remain underweighted with less than optimal and prudent holdings.

I expect participation rates will rise in the months and years ahead as more savers and investors around the world “catch the gold bug” and begin to see the virtues of gold as a reliable store of value and insurance policy against an assortment of risks to their economic and financial wellbeing.

Contributing to increasing participation has been the introduction and growing popularity of gold exchange-traded funds (ETFs) from one country to the next.  Gold ETFs are gold-backed stock-market securities that track the ups and downs of the metal’s price and represent an ownership interest in actual bullion held on behalf of fund investors.

As stock-market securities they attract investors for whom direct ownership of bars or coins may be too cumbersome . . . and ETFs allow some institutional investors prohibited from owning physical commodities or futures contracts a legal loophole, if you will, through which they have bought many tons of metal.

On a cautionary note, gold exchange-traded funds not only allow investors to easily and quickly accumulate gold . . . these ETFs also allow investors to easily and quickly shed their gold holdings.  At times, this has contributed to upside volatility with swift appreciation in the metal’s price.  But, ETFs have also contributed to downside volatility - like the sharp correction we have suffered through in recent months.

Another interesting vehicle that is raising participation, because of its appeal to some investors, is the internet purchase or trading platforms -offered by some gold retailers as well as a variety of financial-service firms - that gives buyers or retail traders direct and immediate access to the market.

These investment vehicles are making gold more accessible and more mainstream to more investors around the world - and the result, in economist-speak, is a permanent upward shift in the demand curve such that the future long-term average price, stripped of cyclicality, will be much higher than the average price over the past decade or two.

My Gold Price Forecast

With these bullish building blocks in mind, let me reiterate my personal forecast of the future price of gold:

I believe gold’s fortunes remain very bright.  To begin with, gold’s key price drivers remain supportive - and most, if not all, will continue to support the rising price for at least a few more years.

Although gold-price volatility - and occasional big declines in the metal’s price - will lead many to prematurely proclaim the death of gold, I believe the bull market has plenty of life in it.  My advice to gold investors is to use these sell offs, when they occur, as opportunities for scale-down buying.

In my view, it is only a matter of time before we see gold break through the $2,000 an ounce level.   Notwithstanding the recent sharp price decline, I wouldn’t be surprised to see gold at this level during the first half of next year . . . followed by $3,000, $4,000, and possibly even $5,000 (or still higher) in the middle to late years of this decade.

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Up, Up, and Away: The Bullish Case for Gold

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Keynote Speech by Jeffrey Nichols
The New York Hard Assets Conference - May 9, 2011

The recent correction in precious metals prices and mining shares has led some investors, analysts, and financial journalists to conclude we’ve already seen the ultimate bull-market peaks in gold and silver.

I’m here today to tell you otherwise – but please don’t mistake me for a gold bug. Although, I believe quite strongly that its price will go much higher in the next few years, I don’t think there’s anything magical about the yellow metal.

The future price of gold is a function of past and prospective world economic, demographic, and political developments. My job for the next forty-five minutes is to briefly review some of these trends and developments – and let you come to your own conclusions.

Gold’s Bullish Building Blocks

There is no simple answer or single reason why gold has been moving from strength to strength for some ten years now. Here’s my list of eleven factors fueling gold’s ascent:

· First, U.S. Federal Reserve policy characterized by low or negative real interest rates and unprecedented central bank monetary creation.

· Second, the U.S. federal budget impasse, rising U.S. sovereign debt, and eroding U.S. creditworthiness.

· Third, the ongoing and expected future depreciation of the U.S. dollar in world currency markets.

· Fourth, accelerating global inflation – with high and rising agricultural and industrial commodity prices leading the way.

· Fifth, fear of sovereign debt defaults and bank failures in one or more of Europe’s “periphery” economies. These countries, despite tax increases and deep spending cuts, continue to see their debt ratings and ability to refinance both government and private-sector bank debt deteriorate. Moreover a widening economic schism across the continent calls into question the viability of Europe’s common currency, the euro.

· Sixth, the continuing civil war in Libya and political unrest across North Africa and the Middle East – and the threat to future oil supplies.

· Seventh, the growing affluence of the emerging-economy nations and the associated growth in gold demand – especially the two big population countries, China and India.

· Eighth, central bank buying by countries under-invested in gold and overexposed to U.S. dollars.

· Ninth, the development and maturation of new gold investment channels, especially gold exchange-traded funds, that make it easy for investors to buy physical metal.

· Tenth, the legitimization of gold as an investment class and the expansion of investor interest among retail and, importantly, institutional investors – including hedge funds, pensions, endowments, and insurance companies.

· Eleventh, no more than marginal growth in world gold-mine production for at least the next five years – while some of the gold-mining nations, including China and Russia, absorb more of their own production for domestic jewelry consumption, investment, and additions to central bank reserves.

Together these bullish factors are responsible for a growing gap between new mine supply and aggregate demand – a gap that can be closed only by much higher prices in the years ahead.

American Economics

Let’s look more closely at some of these bullish factors beginning at the epicenter of today’s world’s economic crisis – Washington D.C.

The U.S. economy still faces significant and painful adjustments in the years ahead following many years of profligacy, years in which our government sector and many private households simply spent more than we could afford, on things we didn’t need, with money we didn’t have.

Despite the rhetoric from Democrats and Republicans alike on the need to tackle the country’s deficit and rising debt, there is little evidence that meaningful and sufficient steps will be taken any time soon – that is, unless a run on the U.S. dollar forces “emergency” measures sooner rather than later.

The U.S. federal government came close to shutting down not too many weeks ago – and the rancor in Washington will likely pick up as we again approach the federal government’s debt ceiling and the 2012 federal budget debate gathers steam.

It is likely that continued discord in Washington will leave our central bank, the Federal Reserve, with the difficult, if not impossible, task of maintaining orderly U.S. and world financial markets in the face of diminishing willingness on the part of foreign central banks and institutional investors to continue funding America’s federal financing gap.

How the Fed maneuvers between rising inflationary pressures, on the one hand, and a sluggish economy with unacceptably low GDP growth and unacceptably high unemployment remains anyone’s guess.

So, even if the Fed discontinues its policy of quantitative easing with the expiration of QE2 this June, before long it may have to continue buying U.S. Treasury securities because foreign central banks and private investors will be unwilling to do so without much higher interest rates.

One thing is for sure: Without significant and meaningful U.S. fiscal reform the dollar’s role as the preeminent world currency and official reserve asset will likely continue to diminish.

The announcement a few weeks ago that the world’s largest bond fund, PIMCO, would no longer hold U.S. Treasury obligations may be a harbinger of things to come.

Investor concern about U.S. government debt was further underscored last month by Standard & Poor’s surprise warning, issued on April 19^th, that America might lose its “triple-A” rating if it doesn’t act swiftly to address the federal deficit and reverse the growing mountain of federal debt.

Unfortunately, the fiscal austerity demanded by financial markets – whether in the form of spending cuts, tax increases, or some combination of the two – will, in the short run, act as a drag on the economy.

To counter the negative economic effects of fiscal tightening, the Federal Reserve, for all its rhetoric to the contrary, will be compelled to step even harder on the monetary accelerator. For this reason, I think we are likely to see another round of quantitative easing (QE3) with implications for future inflation, the U.S. dollar exchange rate, and the price of gold.

In fact, I think the Fed and U.S. Treasury are intentionally targeting a weaker dollar (to stimulate the domestic economy through the trade balance) just as they are targeting a higher inflation rate (to erode the real value of our debt as a percentage of nominal GDP).

The result will very likely be a replay of the 1970s – a decade of sub-par economic activity, high unemployment, rising world commodity prices (especially oil), double-digit inflation, and a booming gold market.

For now, at least, the U.S. dollar remains the number one world trade and official reserve currency only by default. There is simply nothing ready to take its place.

I believe we may move gradually toward a multi-currency system where an array of national currencies, possibly along with IMF Special Drawing Rights and maybe even gold, will function with much less dependence upon the U.S. dollar.

Interest Rates and Gold

A growing number of economists and Fed watchers believe the United States will start raising interest rates later this year or early in 2012. Whenever policy rates begin to rise, it will be too little, too late, to stem the upward march in the yellow metal’s price.

We have already seen the European Union, the United Kingdom, China, India, Brazil and a number of other major economies raise their own domestic interest rates in recent months. The prospect of more rate increases by these countries, joined by the United States, has some gold investors and analysts worried gold prices will turn south.

But, so far, in just about all of these economies, real “inflation-adjusted” interest rates remain quite negative – particularly if you allow for significant under-reporting of actual inflation rates in these countries. As long as nominal interest rates remain below actual inflation rates, there is no reason to believe that investor interest in precious metals will diminish . . . but there is every reason to believe that investors will want to hold more gold as their currencies continue to lose purchasing power.

Breaking Up Is Hard To Do

Meanwhile, several European countries with their backs to the wall (including Greece, Ireland, Portugal, and Spain) are slashing government spending so deeply that economic activity is shrinking, unemployment rates are rising, and many ordinary folds are rioting. Despite spending cuts and tax increases, government revenues are falling.

As a result, rather than improving their creditworthiness, the “periphery” countries will see their credit ratings marked down still further, forcing the European Central Bank to bail out its most?endangered members yet again by its own program of quantitative easing through the purchase and monetization of member?country sovereign debt.

Safe-haven capital flight from the questionable euro into both the U.S. dollar and gold will contribute to the metal’s expected appreciation and, at the same time, mask the greenback’s inherent weakness.

In my view, the only thing now holding the European single?currency monetary system together is the high cost – and seeming impossibility – of managing a break?up. Even if the euro somehow survives, its role as a second?string reserve asset has been badly damaged.

A tarnished euro, periodic funding crises, and fears of a euro break?up will benefit gold in the years ahead – even if the lion’s share of scared money and safe?haven demand find shelter in U.S. dollar financial markets.

To sum up the economic situation: I don’t think either the United States or European economies or currencies are heading toward total collapse. Instead, I think we’ll muddle through with several years of sub-par economic activity, painfully high unemployment, and high, but not hyper, inflation.

Food and Oil Lubricate the Gold Market

Accelerating global inflation is, to be sure, a monetary phenomenon, the result of unprecedented monetary creation by America’s central bank, the Federal Reserve, and most the central banks around the world. Simply put, we have had too much money chasing too few goods and services.

But there’s more to the story than just too much money. Commodity prices are rising because millions, if not trillions, of people living in China, India, and other emerging economy nations are enjoying unprecedented growth in national wealth and personal incomes.

Even if economic growth decelerates somewhat this year and next in these populous nations, as some economists now anticipate, they will nevertheless continue to pursue commodity-intensive infrastructure development (think steel, copper, aluminum, cement, etc.).

And, similarly, slower growth or not, millions of households in these countries will have the means to buy more commodity-intensive consumer goods than ever before.

As a result, high and rising food and agriculture prices are under pressure from a healthy rise in personal consumption in these nations. People with a few more yuan or rupees in their pockets are now eating better, eating more, and eating more grain-intensive “meaty” western-style diets.

So, high and rising global food prices are, in part, a monetary phenomenon . . . and, in part, they are demand driven as millions of consumers eat better – but, in recent years, there is still more to the rise in food prices.

Agricultural inflation is also a consequence of weather-related problems in some of the planet’s most important grain-, corn-, and rice-producing regions: Too much rain, or too little, combined with record heat waves in some places, has taken a big bite out of food production. Now, dryness and weather-related planting delays are threatening poor harvests again in the 2011-2012 crop year.

Many climatologists claim agricultural supply problems, as we have seen repeatedly in recent years, are a symptom of global warming – and are likely to continue, if not worsen, in the future.

High food prices also have had a profound indirect affect on world inflation: Indeed, the high cost of food has been politically destabilizing in some of the countries where food accounts for a big share of household budgets. Remember, earlier this year, high food prices were credited with triggering rioting, unrest, and revolution – first in Tunisia, then in Egypt.

In turn, conflict and political uncertainty has affected world oil markets – and, as we all know, pushed the price of oil (and other energy products) much higher with immediate consequences for inflation everywhere.

Many oil analysts had been warning that oil prices would be heading much higher even before the outbreak of political unrest and revolution in North Africa and the Mideast, due to the growth in demand for oil from both the emerging economies, namely China and India again, and from some of the oil-producing nations themselves.

So, it looks like households around the world – in the United States, Europe, India, China, Latin America, and Africa – will have to endure rising prices for food, energy, and other commodities for a host of complicated reasons beginning with but not limited to excessive monetary growth from one country to the next. Whatever its cause, accelerating global inflation spells higher gold prices ahead.

Chinese Liberalization Promotes Rising Demand

Let’s turn our attention to China: This country has already had – and will continue to have – a profound influence on the world gold market and the metal’s price.

Private gold investment was banned and the market was tightly controlled for more than five decades following the Communist Party takeover in 1949. Ever since the legalization of gold investment and the gradual liberalization of the market beginning in 2002, the Chinese appetite for gold has been growing by leaps and bounds.

Much of the growth in China’s gold demand over the past few years has been a result of the government’s liberalization of the domestic gold market, its encouragement of private gold investment, and the development of new investment vehicles and channels of distribution.

As a result, China has become a powerful driving force in the world gold market – and this trend is likely to continue, if not accelerate, in the next few years reflecting demographics, strong economic growth, rising personal incomes, worrisome inflation, and the continuing development and maturation of the gold-market infrastructure.

China’s first gold exchange-traded fund (a hybrid that invests in overseas gold ETFs) was launched this past December and was quickly fully subscribed. I anticipate Chinese-listed gold exchange-traded products – and other new channels of gold investment – will grow rapidly in the next few years with a significant and lasting effect on the world gold market and the U.S. dollar gold price.

China – Continuing Growth Despite Monetary Tightening

The recent and prospective monetary tightening by China’s central bank, the People’s Bank of China (the PBOC), will not – in my opinion – diminish the country’s growing appetite for gold jewelry and investment.

PBOC policy actions – raising interest rates, adjusting bank reserve requirements, and allowing some gradual appreciation in China’s currency, the yuan – are in response to super-strong economic activity and uncomfortably high domestic price inflation.

But, real interest rates in China (that is after adjustment for inflation) are actually falling . . . and have become more stimulative and supportive of gold. Moreover, Chinese monetary authorities would like to see more, not less, private gold investment, hoping to reduce speculative investment in real estate and the stock market.

At most, Chinese authorities are trying to cool a hot economy and slow the annual rate of GDP growth from around ten percent to a more sustainable pace around seven percent. I have long argued that the country’s long-term bullish influence on the world gold market would continue as long as China’s economy continues to chug along at a moderate rate – with or without worrisome rates of consumer price inflation.

If inflation accelerates, as it has recently, led by rising food and commodity prices, that’s just icing on the cake, boosting gold demand still more.

Indian Demand Heats Up

China isn’t the only giant shaking up the world of gold. India’s appetite for gold is also hot like curry.

As in China, economic growth has been strong with GDP rising smartly – and inflation has been heating up as well.

India has historically been a very price-sensitive market for precious metals. Typically, buying interest falls as prices rise . . . and, at higher prices, India women are known to take profits, cashing in their bangles and chains, so much so that Indian gold scrap can, at times, be an important source of supply to the world market.

In contrast to the historical experience, we are now seeing much less price sensitivity of demand as Indian consumers have adjusted quite quickly to record high gold prices. Even at recently prevailing prices in the $1400 to $1500 an ounce range, Indians still seem eager buyers – suggesting a psychological re-evaluation of gold-price prospects.

As in many other countries, Indian gold investment is benefitting from securitization and the growth in gold exchange-traded funds. First introduced in 2007, there are now 10 gold ETFs with physical gold held on behalf of investors totaling more than half a million ounces (about 15.5 tons) when I last checked a few months ago – and holdings will likely grow as more mainstream stock-market investors participate.

India and China are very important markets for gold, in part, reflecting their huge populations and growing wealth. But there are many other countries across Asia and the Mideast that share an historical, cultural, and even religious affinity to gold as a traditional monetary medium for saving and investment. Even gold jewelry in many of these countries is purchased for its investment characteristics, as a symbol of wealth and social status, and as an amulet or talisman bringing good fortune to its owner.

Longer term, as many of these countries prosper and as their share of global income and wealth continues to increase, they will demand a growing share of the world’s above-ground stock of gold for jewelry, for investment, and for central bank reserves.

Importantly, much of the gold bought by these countries will probably never come back to the market, at least not for many years to come and only at much higher price levels or if political and economic developments prompt distress sales, something we will not likely see in the next few years.

Central Banks Buying More

Central banks collectively have taken a much more positive view of gold in recent years.

Just last week, it came to light that Mexico’s central bank, the Banco de Mexico, purchased some 93.3 tons this past February and March. That’s about 3.5 percent of annual world gold-mine output worth more than $4 billion at recently prevailing prices.

After net sales of roughly 400 to 500 tons a year over the prior decade, the official sector (including central banks, the International Monetary Fund, and sovereign wealth funds) became a net buyer of gold in 2009.

Net official purchases may have totaled as much as 100 to 200 tons in each of the past two years, even allowing for the IMF’s 403 ton gold sales program, which ended some months ago.

Last year, net official purchases continued as a number of central banks, principally in Asia, added to their official reserves while sales by European central banks were minimal – and have now virtually ceased except for some small reductions for domestic gold coin programs.

Officially published data on central bank gold transactions are not to be believed as some countries buy gold surreptitiously, choosing not to report purchases . . . and data on sovereign wealth funds are, for the most part, unreported. So, it’s not possible to get an exact reckoning of net annual purchases or sales by the official sector.

China, for example, announced two years ago that its central bank had purchased 454 tons in the prior six years – but it chose not to report these purchases until April 2009. Some observers, myself included, believe that China continues to buy significant quantities on a regular basis, possibly 100 tons or more annually, probably all of which comes from domestic mine production.

Saudi Arabia also added significant quantities of gold – 180 tons, in fact – to its official holdings over the past few years – but did not report these purchases until last June. It is likely that the Saudi Arabia Monetary Authority also continues to buy . . . along with some of the other oil producers with dollar-heavy, gold-underweighted official reserves.

The People’s Bank of China, the PBOC, and other central banks have an incentive to buy gold discretely and surreptitiously – simply because the announcement and acknowledgment of their buying programs would likely affect the yellow metal’s price and raise these central bank’s acquisition costs.

What we do know is that the list of countries that have bought gold since the beginning of 2009 continues to grow. China, Russia, India, Saudi Arabia, and now Mexico have been the biggest buyers. Other gold-buying countries include Kazakhstan, Sri Lanka, Mauritius, Venezuela, Bolivia, the Philippines, Thailand, and Bangladesh. Even the Ukraine and Tajikistan central banks have added small amounts to their official reserves in the past year.

Meanwhile, in recent days, it has been suggested by senior German officials that Portugal ought to sell some of its official gold holdings to ease its difficult debt problems. Should such a sale take place it is very likely that a number of other central banks would quickly line up as potential buyers, with Germany’s Bundesbank and the European Central Bank probably at the front of the line.

Recent year gold sales by the IMF have demonstrated that large-scale official sales need not disrupt the market – and that central banks underweighted in gold are willing buyers when given the opportunity to make off-market purchases.

Increasingly, many investors – both retail and institutional – are looking at these official-sector gold purchases and concluding they, too, should be diversifying their savings and investments with some physical gold.

Rising Participation

A few weeks ago, a big headline in the Wall Street Journal proclaimed “World is Bitten by the Gold Bug.” Gold bears seem to think that suddenly everyone has gone mad buying gold – and, because so many piled so quickly and recklessly into gold, they argue we have already seen the top and the metal will just as quickly lose value as investors shed their holdings.

Even though more people than ever before are buying gold, participation by both retail and institutional investors in the United States and many other countries remains very low. Moreover, many investors already holding gold remain underweighted with less than optimal and prudent holdings.

I expect participation rates will rise in the months and years ahead as more savers and investors “catch the gold bug” and begin to see the virtues of gold as a reliable store of value and insurance policy against an assortment of risks to their economic and financial wellbeing.

Of great importance to the future price of gold has been the introduction and growing popularity of gold exchange-traded funds (ETFs) from one country to the next. Gold ETFs are gold-backed stock-market securities that track the ups and downs of the metal’s price and represent an ownership interest in actual bullion held on behalf of fund investors. As stock-market securities they attract investors for whom direct ownership of bars or coins may be too cumbersome . . . and ETFs allow some institutional investors prohibited from owning physical commodities or futures contracts a legal loophole, if you will, through which they have bought many tons of metal.

On a cautionary note, gold exchange-traded funds not only allow investors to easily and quickly accumulate gold . . . these ETFs also allow investors to easily and quickly shed their gold holdings. At times, this has contributed to upside volatility with occasional swift appreciation in the metal’s price. But, ETFs have also contributed to downside volatility – like the sharp correction we saw just last week.

Developments in key geographic markets along with new more convenient investment vehicles are making gold more accessible and more mainstream to more investors around the world – and the result, in economist-speak, is a permanent upward shift in the demand curve such that the future long-term average price, stripped of cyclicality, will be much higher than the average price over the past decade or two.

My Gold Price Forecast

I see the clock ticking, so let me say something very briefly about world gold mine output and wrap up with my gold-price expectations.:

While production has increased in the past couple of years, growth in total ounces produced will continue to be modest for the next few years, maybe 1.5 to 2.0 percent annually – and total world mine production will continue to fall far short of the expected growth in jewelry, investment, and central bank demand for at least the next five years or longer.

Well, now that we’ve circumnavigated the world of gold and accounted for the key trends and developments, what can we say about the metal’s price prospects?

I believe gold’s fortunes remain very bright. To begin with, gold’s key price drivers all remain supportive . . . and there are so many of them, so many reasons to expect the long-term trend will continue upward for at least another few years.

What’s more, recent market activity – from a technical or chartist perspective – rather than signaling an end to gold’s decade-long advance, strengthens the case for a snap-back in the metal’s price with new all-time highs in the months ahead.

It’s sometimes said that forecasting is particularly difficult, especially when it’s about the future – and this is even more so when it comes to forecasting the future price of gold. It’s more an intuitive art than an exact science . . . although many an analyst and economist would have you believe otherwise.

That said, it’s my hopefully well-informed opinion that the price of gold will very likely hit $1700 an ounce by the end of this year – and I wouldn’t be at all surprised to see it even higher.

At the same time, gold prices are likely to remain volatile registering big short-term swings both up and, as we saw last week, down. Sizable intermittent price declines may lead some investors, and more than a few journalists, to question the bull market’s staying power. I can only warn you not to get prematurely caught in a bear trap.

Looking further out, I believe we are likely to see gold at $2000 an ounce in the next year, and possibly $3000 or even $5000 an ounce before the gold-price cycle moves into reverse in the middle or later years of this decade.

Filed under: Gold Briefs, Speech | American Precious Metals Advisors, central banks, China, ETFs, euro, European Central Bank, Exchange-Traded Funds, fiscal policy, gold, gold investment, gold price, India, inflation, Jeffrey Nichols, Mideast, mine production, monetary policy, Quantitative Easing, Russia, sovereign risk, U.S. dollar|No Comments

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

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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

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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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