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Gold - Just an Innocent Bystander

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“At some point, however, we will see a correction, perhaps a sizable one.  After all, even strong bull markets never move up in straight lines.  I would not be surprised to see gold stumble - falling back $100, $200, or even $300 - before prices begin working their way higher once again.”

That was my view published on NicholsOnGold.com in late August.

Gold has certainly taken a dive - and could stumble further in the days immediately ahead - but I think we will see the yellow metal begin its comeback sooner rather than later, possible in the next few days.

This summer we raised our year-end price forecast to $1,850 an ounce - but remained reluctant to adjust our expectations upward as the price moved past this level and briefly traded over $1,900 an ounce in early September.

Although physical demand in world bullion markets remained firm, it seemed to me that the price was moving up too fast too soon as institutional speculators extended their “long” positions in “paper” derivative markets.

Shoot the Speculators

Now - rather than any dramatic reversal in world physical markets - it looks like the precipitous price decline in recent days can be blamed entirely on these same speculators (including some prominent hedge funds and the trading desks of the big Wall Street banks) reversing their positions or cashing out of gold altogether.

Nothing that has occurred in the past few days in any way diminishes my long-term enthusiasm about gold-price prospects.  The same bullish gold-market fundamentals and macroeconomic trends that I have been discussing for many years now remain in place and promise significantly higher gold prices over the next five years or longer.

It is important to remember that violent sell-offs in equity and other asset markets typically spill over into the gold market . . . but after an initial selling wave, gold tends to disassociate itself from and act independently other asset markets.

At first, when other assets are under extreme pressure, as has been the case this past week, gold’s immediate reaction reflects reflexive selling by institutional speculators - including momentum, program, and other “black box” traders.  Short-term trading in derivative markets may, at times, produce a great deal of gold-price volatility but, in my book, it does not affect the long-term price trend.  In a sense, gold is an “innocent bystander.”

Nothing We Haven’t Seen Before

While the magnitude of gold’s decline seems stunning in absolute terms, keep in mind it is not unusual for gold prices to correct by 10%, 15%, 20% or even more after a run-up the likes of which we’ve seen this year.  Old timers may recall the 1970s, when we saw at least a couple of bigger percentage corrections in the midst of a long-lasting bull market.

Now, from its September 6th all-time high around $1,923 an ounce to this Friday’s (September 23rd) low around $1,628 an ounce in New York trading, we are off just about 15 percent - certainly not so much when you consider the previous advance . . . certainly not so much to those who remember gold’s volatile price history . . . and certainly not so much as to cause much alarm among those who pay close attention to gold’s fundamentals.

Fundamentals Count

And speaking of fundamentals — with the exception perhaps of India — physical demand in recent days has held of fairly well.  Meanwhile, it is not unusual for more price-sensitive trading-oriented Indian gold dealers to pause, at times like this, for the dust to settle before stepping back as buyers.  For sure, there is nothing here to diminish India’s long-term appetite for gold.

Meanwhile, my China contacts report no immediate diminution in retail gold demand from the world’s biggest national gold market.  Driving Asian demand - in India, China, and elsewhere has been the continuing rise in household incomes in tandem with worrisome inflation - and this pro-gold combination is unlikely to change in the foreseeable future.

Watch the Central Banks

For the past few years (in speeches, published articles, client reports, and on my website NicholsOnGold.com), I’ve been talking a lot about the revival and growth of central bank gold interest - and its long-term significance to the market and the future price.

I believe that a few central banks - central banks that have been fairly regular buyers, acquiring gold month in and month out - have already stepped up their purchases in reaction to the lower, more attractive, price levels now prevailing.  And other countries are likely to add to their own gold reserves in the days ahead as it becomes more apparent this correction has run its course.

The central banks of Russia and China (which does not report or publicize its on-going gold purchases) are the first that come to mind, but quite possibly other central banks will also use this episode of gold-price weakness to acquire metal without causing any overt market reaction.

In my book, gold’s own supply/demand situation and other recent-year institutional or structural changes in the gold market per se (such as the introduction and growth of gold exchange-traded funds or the legalization of private gold investment in China) suggest more gold price strength ahead.

And Shoot the Politicians Too

So, too, does the inability and disarray among of our economic policymakers and politicians, those entrusted with our financial and monetary wellbeing, to frame appropriate policies that would deal effectively with today’s economic realities.

Indeed, U.S. and European economic prospects continue to deteriorate, suggesting we will see still more desperate monetary stimulus from the Fed and the European Central Bank (the ECB) before the end of this year.

Here in the United States, the Fed will be facing continued signs of renewed recession or recession-like business and employment conditions.

Across the Atlantic, the ECB will be struggling to prevent the approaching Greek sovereign debt default and the insolvency of some European banks holding Greek sovereign debt.  Some fear this would be a catastrophe far worse than the Lehman Brothers bankruptcy - with dire consequences for the world economy.

While these problems are unlikely to trigger any immediate policy response from the Fed or the ECB in the next week or two, as pessimism grows among investors and traders, expectations of further monetary accommodation could stimulate more investment demand in the days and weeks ahead.

So, too, could U.S. Congressional bickering and inaction on both the U.S. Treasury debt ceiling and on the Federal budget impasse as these issues again become headline news.

Long-Term Buyers Rule

To recap:  Short-term trading in derivative markets may, at times, produce a great deal of gold-price volatility but, in my book, it does not affect the long-term price trend.  What governs the price of gold over the long term are the market’s real-world supply and demand fundamentals - and these have been decidedly bullish and are becoming even more so.  Hence, my long-standing forecast of much higher gold prices in the next several years.

Importantly, to the gold-price outlook, today’s buyers, both private investors and central banks, are likely to be long-term holders.  Much of this gold, once bought, is unlikely to be resold any time soon even at much higher price levels.  For central banks, the holding period will be measured in decades if not longer.  This promises less liquidity, more volatility, and much higher prices in the years ahead.

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Dog Days of Summer: Cooling Off for Gold Unlikely

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The days and weeks ahead could be tumultuous for gold with the yellow metal’s price primed to move one way or the other depending on news from European finance ministers, the European Central Bank, the Greek Parliament and, last but not least, the Fed’s FOMC policy-setting committee and Chairman Bernanke’s news conference later this week.

Technically, gold remains range bound with good support, as we saw last week, between $1515-$1522 and overhead resistance in the $1545-$1555 range.  A break out in either direction, perhaps triggered by news of a more fundamental nature, could signal a bigger move.  Should prices fall, we would view this as a “scale-down” buying opportunity.

Zoned Out

Eurozone finance ministers meeting over the past week-end once again could not agree on a bail-out package for functionally bankrupt Greece, which runs out of cash to pay its debts in the next few weeks . . . and even if they could agree the European Central Bank (ECB) threatens to declare a Greek default if private lenders don’t share the burden with Greece’s public-sector creditors.

The chief risk is that a number of major French and German banks would have to mark down the value of Greek debt on their books, leaving them undercapitalized and in need of recapitalization by the ECB to remain solvent.  Moreover, as credit ratings decline for all of the peripheral countries, their rising interest costs to refinance maturing debt make it all that much more difficult to keep their heads above water.

Quite possibly the Greek parliament in a vote of confidence this week for Prime Minister Papandreou will accept more austerity measures as part of the deal to win Eurozone funding . . . but even this “favorable” outcome will only provoke more rioting in the streets of Athens by public-sector workers unwilling to accept more of the burden of adjustment and a further erosion in their living standards.

Chances are the Eurozone finance ministers and European Central Bank will find a way to postpone the hard decisions that will ultimately end Europe’s failed experiment with a single currency.  But, sooner or later, whatever happens, it is difficult to imagine a scenario in which gold does not emerge the winner, even if the immediate short-run reaction is a sell-off in gold, as we have seen at the start of past financial panics (think Lehman Brothers) as investors seek the liquidity of cash.

Eyes on the Fed

Meanwhile, U.S. and world stock markets are now undeniably in a downtrend if not a full-blown bear market . . . and incoming economic indicators are pointing to a second phase in what is quickly becoming a double-dip recession.

So far, most Washington politicos and Wall Street bankers are in denial, refusing to see the worsening signs of renewed recession.  Instead, they are arguing for restrictive economic policies that, if enacted, would exacerbate the developing downturn . . . and which the history books would liken to the policy mistakes of the 1930.

The Fed also fails to see, at least publically, the writing on the wall - and is preparing to end its program of monetary easing through the purchase of government bonds, a program that both creates new money in an attempt to liquefy the economy and finances the Federal debt at low interest rates without having to go hat in hand to our foreign creditors.

All eyes and ears in the gold and world financial markets will be focused later this week on the June FOMC meeting and Chairman Bernanke’s press conference for the Fed’s assessment of the economy, inflation and employment prospects, and any hints of forthcoming adjustments to Fed policy.

If the Fed, indeed, ends its program of quantitative easing at month-end as scheduled, it will - in my view - soon be forced by rising unemployment and sluggish business activity to resume monetary stimulus in one form or another.  Perhaps not QE2 - a second round of quantitative easing might be difficult to swallow - but a rose of some other name.

We think the only viable and politically acceptable means for America to dig itself out of its unbearable burden of excess debt - federal, state and local, housing, and other private-sector debt - is to pursue a policy of higher inflation that will deflate the ratio of outstanding debt to nominal gross domestic product (GDP) to historically acceptable and manageable levels.  Indeed, under Chairman Bernanke’s lead, the Fed is already quietly pursuing this policy of targeting somewhat higher U.S. price inflation.

Pursuit of a mildly inflationary monetary policy will not however excuse the Congress and Administration from developing a responsible believable program of long-term spending restraint and deficit reduction.  However, now is not yet the time to impose these restrictions on an ailing economy - though articulation of a realistic bi-partisan plan for long-run deficit and debt reduction would help calm world financial and currency markets.

Adjusted for consumer price inflation, using official government data (data that tends to seriously underreport actual inflation felt by American households), suggests that gold should be selling today for at least $2500 an ounce . . . and considerably more if we were to account for the government’s underreporting of actual inflation.

Paper Tiger

Europe’s troubles and the collapse of the euro as we now know it will make the dollar look good by comparison . . . and a rising dollar against the euro could briefly dent gold as traders fall back of the historical inverse relationship between gold and the U.S. dollar exchange rate vis-a-vis competing currencies in world foreign exchange markets.

But a rising dollar would be nothing more than a “paper tiger” soon to be deflated by America’s budget mess, sagging economy, and renewed U.S. monetary stimulus.  As noted at the outset of this brief essay, a setback for gold should be greeted by investors as another buying opportunity as it surely would by those central banks wishing to build gold holdings without disruptively sending gold prices higher.

Hot Summer Ahead

Most gold pundits are anticipating a traditionally quiet summer of the yellow metal.  Historically, gold prices have exhibited strong seasonality - with relative weakness in the Northern Hemisphere summer months and maximum relative strength late in the calendar year.  To a large extent, this seasonal pattern has been a reflection of culturally determined buying habits in the major gold-consuming countries and regions.

For example, India - often the biggest gold-consuming nation - usually enjoys a pick up in gold buying in September when harvests boost income and spending in the agrarian sector, a sector with a high propensity to buy gold for jewelry or saving with any excess income that comes their way.  Around the same time begins a string of festivals that continue into May, festivals that are propitious for marriage, hence requiring gold dowries.  These festivals are also believed by many Indians to be a lucky time to buy gold as an investment.

Also in September, in the United States and other Western nations, jewelry manufacturers begin stocking up and fabricating gold jewelry for the December Christmas gift-giving season followed closely by the February 14th Valentine’s day, which is also accompanied by much gold jewelry gifting.

Around the same time, the Chinese or Lunar New Year occurring in January or February heralds in a period of gold demand for jewelry fabrication and gift giving across Greater China . . . and is also seen by many as a propitious time for gold investment.

But these seasonal factors are diminishing - largely because investment demand, which knows no season, is growing rapidly in importance and, to some extent, displacing jewelry demand.  First, there is the expansion of secular, long-term, hoarding demand for gold reflecting the growth in incomes in Greater China and India.  As incomes rise, so does demand for gold jewelry and investment bars, in these countries - which increasingly occurs independently of seasonal, festival, marriage, or gift-giving considerations.

In many countries, too, we are seeing an increase in official or central bank buying:  In recent years the list of gold buyers has included China, India, Russia, and a host of other countries for whom seasonality plays no role whatsoever in the decision to accumulate gold reserves and diversify away from the U.S. dollar.

And, importantly, powerful economic and geopolitical forces that also exhibit no seasonality are now increasingly governing short-term investment and speculative trading demand for gold.  The extent to which the typical summer “doldrums” for gold will be overwhelmed by unfolding economic and political events remains to be seen.

But, clearly, gold-price direction and volatility will be affected in the weeks and months ahead by the economic developments discussed above, namely U.S. monetary and federal budget policies as well as Europe’s sovereign debt crisis and the coming disintegration of region’s common currency.

Moreover, what we haven’t talked about the potential for events across North Africa and the Middle East to trigger a rush into gold - because instability spreads to Iran and/or Saudi Arabia; because Afghanistan or Iraq deteriorate into all-out civil war; because democratic reform in Egypt or Tunisia is replaced with new tyrants less friendly to the West; because regime change in Libya, Syria, or Yemen herald in worse; or because oil supplies and prices become less secure.

Clearly, events in this region are not proceeding as first imagined by Western powers.

So, it remains to be seen if the coming summer will be a period of calm and relative stability for gold . . . or a period of great “sturm und drang” with sharply rising prices and greater volatility.  Odds favor the later.

Whatever the immediate future holds in store, we remain firmly committed to our bullish gold-price forecast with the metal trading at or close to $1700 later this year with still higher prices in the years ahead.

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In Brief: The Bullish Case for Gold

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Stimulative U.S. monetary policies, irresponsible U.S. fiscal policies, and an uncertain outlook for the U.S. dollar.

Despite some hopeful economic indicators here and there, persistent recession-like business conditions - especially the weak housing sector and high unemployment - gives the Federal Reserve no alternative than continuing its accommodative and ultimately inflationary policies.

Higher industrial and agricultural commodity prices and rising inflation expectations will promote investment and speculative demand for gold as an inflation hedge.

Global commodity inflation is already on the rise with higher prices for food, oil and raw materials already up sharply during the past year.  Despite economic slack in the United States and Europe, rising demand in the fast-growing emerging nations is creating shortages and higher prices everywhere - and this is now beginning to show up in U.S. and European consumer price inflation.

Increasing central bank interest in gold as an official reserve asset.

China and Russia will continue to buy significant quantities of gold from their domestic mine production.  Meanwhile, some of the rich oil-producing nations will follow Saudi Arabia’s recent lead, buying gold in the open market, and the list of other countries adding to official gold reserves will continue to grow.

Strong jewelry and investment demand across much of Asia — especially China and India.

Reflecting growth in personal incomes and household wealth, the development of local markets, and the introduction of new gold investment vehicles will support rising gold demand even at much higher prices.

Growing participation from both retail and institutional investors in the United States and other mature industrial nations.

Gold is increasing perceived by Western investors as a legitimate investment class - and the rise of gold exchange-traded funds in recent years in making it easier than ever before for investors to participate.

Gold output from new mines in China, Russia, and elsewhere around the world has not been sufficient to replace the drop in supply from old mines in South Africa, North America, and Australia.

Although the past decade’s contraction in annual mine supply may have run its course, growth in world mine output will remain subdued and insufficient to satisfy the continuing strong growth in global gold demand.

Even if higher prices prompt more gold exploration and mine development, it takes many years for major discoveries to result in significant new supply.  Because of the long lags between discovery and actual production, we know with certainty that any growth in mine supply will be limited for the next few years.

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U.S. POLITICS, ECONOMIC POLICY, AND THE FUTURE PRICE OF GOLD

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Gold thrives on political and economic uncertainty . . . and we’ve got plenty of that now that the Republican Party has seized control of the House of Representatives and narrowed the Democratic majority in the Senate.  What’s more, the U.S. Federal Reserve, America’s central bank, is adding to the uncertain political and economic landscape as it embarks on another large dose of monetary stimulus.

Without a doubt, the new arithmetic on Capitol Hill — along with the Fed’s recent policy shift — reinforces the bullish case for gold and raises my confidence that gold prices will rise to $2000 an ounce, then $3000, and possibly higher peaks over the next few years.

Irreconcilable Differences

There’s plenty of rhetoric from some Congressional leaders and the Obama Administration about “working together” to solve America’s economic problems.  But, in the end, irreconcilable philosophic differences on the role of government suggest that the ship of state will remain rudderless — at least with respect to fiscal policy — until the next federal elections in two year.

Not only will the new Republican majority in the House confront a liberal Administration, but there could also be a nasty struggle for control within the Republican Party between its now-more-powerful conservative wing and party moderates . . . and within the conservative wing between the traditionalists and the unconventional Tea Party bloc that has now won a seat at the head table.

Republican leadership will demand across-the-board tax cuts, reduced Federal spending, and rolling back the recently enacted health-care program.  It’s hard to imagine liberal Democrats will swallow the Republican medicine.  More likely, we face more gridlock and more acrimony on Capitol Hill — in short, a dysfunctional government that is incapable of dealing effectively with America’s serious economic problems.

Three Fiscal Indicators

Tax Policy: One of the early indicators of future fiscal policy will be the decision taken to extend or let expire the Bush-era tax cuts that run through the end of this calendar year — or just possibly accept some sensible compromise that would extend the cuts another year or two for all but the wealthiest few percent of tax payers.

Rather than pursue what some consider appropriate counter-cyclical fiscal policy, failure to extend the Bush tax cuts will raise taxes at just the wrong time, taking money and spending power out of the household and small-business sectors.

Others argue the expiration of the Bush-era tax cuts are just the right medicine to reign in our outsized Federal budget deficit and borrowing requirement, a first step toward restoring confidence in the U.S. dollar both at home and overseas — but fiscal restraint at this juncture could easily backfire, slowing or even reversing the hoped-for economic recovery.

In any event, neither course – raising taxes enough to achieve a quick and significant reduction in the Federal budget deficit, nor cutting taxes enough to greatly stimulate a sluggish economy — is politically feasible.

How this controversial fiscal-policy issue unfolds, and it’s long-term effect on the health of our economy, will be one of the big issues affecting gold, the dollar, and other world financial markets in the weeks ahead and, possibly, for years to come.

The Debt Ceiling: Political analysts and economists are also wondering how Congress will deal with the national debt ceiling that now prohibits Federal borrowing above the current legal limit of $14.3 trillion.  Unless Congress votes to raise this ceiling, the Treasury’s borrowing authority will expire early next year.

In the past, Congress perfunctorily increased the ceiling each time Federal borrowing approached its legal limit.  Now, however, a handful of incoming anti-debt, anti-government Tea Party legislators, led by libertarian Republican Senator-Elect Rand Paul, could stall Congressional action to raise the legal limit.

Without the authority to borrow, the Federal government cannot function.  Public spending on even the most essential programs and services would grind to a quick halt.  The Treasury would be forced to default on maturing debt — much of which is held by foreign central banks — and we could find ourselves in a global financial crisis of massive proportions with the dollar sinking fast and gold moving sharply higher.

State & Local Bailouts: Another important — but less-discussed — fiscal policy issue that may soon capture more attention on Capitol Hill and in the financial press is the increasing insolvency of many state and local government entities across the nation.  With the new, more conservative, majority in the House of Representatives the hoped-for bailouts from Washington may not be forthcoming.  Many states operating in the red (including California, Texas, New York, Michigan, and others) must balance their budgets — meaning further belt-tightening, service cuts, more lay offs of public employees (including teachers, policy, firefighters, and office workers), and higher local taxes, all of which will be a further drag on the national economy.

The Fed to the Rescue

With the Obama Administration and a more conservative Congress at loggerheads, it is likely that America’s central bank, led by Federal Reserve Board Chairman Ben Bernanke, will be the only agency capable of acting forcefully in the face of a continuing recession-like economic performance characterized by persistently high unemployment.

But all the Fed can do is print more money — what economists and financial journalists call “quantitative easing” or simply “QE.”  The Fed accomplishes this magic trick by purchasing securities, usually Treasury notes or bonds, in the open market or directly from the United States Treasury.

In addition to injecting more liquidity into the financial system, the Fed’s purchase of securities lowers medium- and long-term interest rates.  It is hoped that lower rates will encourage additional private-sector borrowing — borrowing to finance new productive investment as well as borrowing to refinance existing loans (including home mortgages) at lower interest rates and reduced carrying costs.

Quantitative easing also depresses the U.S. dollar exchange rate as excess dollar liquidity in the United States seeks higher rates of return abroad.  Dollar devaluation against the currencies of those countries running big trade surpluses with the United States will improve our international competitiveness, support American exports, restrict our imports, benefit domestic business activity and create more jobs.  Dollar devaluation is typically associated with gold-price appreciation — and this is yet another factor supporting our bullish outlook for the yellow metal.

The Fed began its policy of quantitative easing with a “shock and awe” spree of monetary creation, purchasing $1.725 trillion in U.S. Treasury, other Federal agency, and Fannie Mae/Freddie Mac mortgage-backed securities. That program, often referred to as QE1, ran from December 2008 to March 2010 — and was an important bullish factor propelling gold prices higher during the period.

Now, the Fed is embarking on a second tranche of quantitative easing.  Last week, following its early November policy meeting, the Fed announced its intention to purchase another $600 billion more in Treasury securities before the end of next year’s second quarter.

In the absence of sensible fiscal-policy alternatives, Fed Chairman Ben Bernanke has chosen, in my view, the least-bad policy path by adopting more aggressive monetary stimulus at this time. Without more action now, the economy would very likely sink further, new job creation would slow further, and unemployment would surely rise.

Underpinning my very bullish gold-price is the expectation that persistent recession-like conditions, especially unacceptably high unemployment, and a continuing fiscal-policy logjam in Washington will force the Fed to adopt still-more stimulative monetary policies for at least another couple of years — policies that sooner or later will be reflected higher U.S. consumer-price inflation, U.S. dollar depreciation, and significantly higher gold prices.

No Quick Fix

All of us want to see policies that will quickly right the economy, rev up business activity, and put the unemployed back to work.  But, unfortunately, a quick fix is not possible.

Few recognize that America’s recent economic problems are structural and were decades in the making, a consequence of excessive household and government spending that was bankrolled by consumer, mortgage, and public-sector borrowing and insufficient productive investment.

America spent, not on updating our national infrastructure or developing 21st century industries or training students and the workforce for the jobs of tomorrow.  Instead, we became a nation of shopaholics, buying things we didn’t need with money many of us didn’t really have, while our government spent excessively on the cost of empire and on social programs that were of admirable intention but no one wanted to pay for.

Countercyclical monetary and fiscal policies cannot fix these structural problems.  To thrive again, we must reduce our outstanding public-sector and private-sector debt — measured as a percentage of gross domestic product or national income.  Contrary to popular belief, higher inflation could be part of the solution.

Inflation Intentions

Although the Fed is officially targeting a small rise in consumer price inflation, I believe Chairman Bernanke is well aware of the much greater inflationary potential arising from the program of quantitative easing.

Printing more money may raise the hackles of sound-money advocates and surely won’t be appreciated by foreign central banks and others holding U.S. dollar debt — but higher domestic inflation and a depreciation of the dollar against the currencies of countries running persistent current account surpluses makes sense and may be the least painful road back toward prosperity.

Inflation erodes the real value (or purchasing power) of outstanding debt and lowers the ratio of total debt outstanding relative to nominal gross domestic product or national income.  Once our debt-to-income ratios are restored to “normal” or “healthy” levels, sustainable private-sector and public-sector spending can get the American economy moving again.

Some will argue that inflation is an unfair “invisible tax” on our creditors . . . and this is certainly true — but so is the lack of employment opportunities for most of our unemployed and the loss of wealth suffered by most American households.

The stagflation of the 1970s — a period of sluggish economic growth and high unemployment — demonstrates that high inflation and a falling dollar can occur even with low rates of capacity utilization and high rates of unemployment, what economists euphemistically call economic slack.

Just as the decade of stagflation gave way to economic renewal during the 1980s, higher inflation in the next few years could ultimately give way to renewed economic strength.

Wise economic policies — although unlikely given our wide domestic political divides — could lessen the pain and accelerate the return to economic health.  But, whatever policy path we find ourselves on, the United States faces difficult times that will be reflecting in a continuing long-term appreciation in gold.

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