Honest Money


“It is hard to find and produce gold, easy to print money,”
observes James Grant, editor of Grant’s Interest Rate
Observer. “We [gold] bulls take comfort in the geological
scarcity of our precious and beloved metal.”

Unfortunately, geological scarcity functions very poorly as
a market-timing tool. “Gold was scarce in each and every
year of the 1980-99 bear market,” Grant admits. But happily
– for those investors among us who get no thrills from
owning a “precious” asset that falls in value – a couple of
developing trends suggest that the nascent gold rally will
gain momentum:

First, the structure of short-term interest rates in Europe
and the United States may encourage rising gold prices,
according to Paul Kasriel, the self-styled chief economist
of Northern Trust Co.

Second, the euro’s recent travails – triggered by the
French vote against the European Constitution on May 29th –
seem to be destabilizing the worldwide currency markets, a
condition that should also encourage rising gold prices.

“Gold really starts to glitter when you can’t get an
‘honest’ return on your money market investments in any
major currency,” Kasriel explains. “That is, when the
inflation rate is above money market rates in all major
currencies, investors turn to gold as a store of value.”

For example, as the chart below illustrates, US short-term
rates began delivering a negative real return in the summer
of 2002 and did not begin to deliver a positive real return
until very recently. It is perhaps no accident, therefore,
that the gold price rallied from about $300 an ounce in
August of 2002 to more than $450 an ounce by the end of
2004. The metal has been languishing ever since, as the
Fed’s rate-hike cycle has lifted short-term interest rates
above the inflation rate.

“In May, the year-over-year percent change in the all-items
U.S. CPI was 2.8%,” Kasriel notes. “The fed funds rate
target was 3.00%. Thus, the inflation-adjusted fed funds
rate was positive by 20 basis points – the first positive
“real” fed funds rate since September 2002.” Because the
fed funds rate is now 3.25%, the inflation-adjusted rate
has jumped to 45 basis points. Meanwhile, Europe’s real
short-term rates have also nudged into positive territory.

In theory, therefore, short-term rates in the US and Europe
both provide competitive real returns versus the inert,
non-yielding precious metal. Nevertheless, ever since the
French vote, gold has been rallying against both the dollar
and the euro…especially the euro. Since May 29th, gold
has advanced only 1% against the dollar, but more than 8%
against the euro.

“I wonder if the gold market is beginning to reflect the
expectation that an honest return on one’s money may be
hard to come by in the not-too-distant future,” Kasriel
muses. “With eurozone economic growth faltering, the
European Central Bank (ECB) is under increasing pressure to
cut its policy rate. It is doubtful that eurozone consumer
inflation would decline by as many basis points as the
interest rate cut. Thus, if the ECB were to lower rates in
the near term, it is likely that the real ECB rate could
turn negative again.”

Likewise, Kasriel believes, the probability is high that
short-term US rates will turn negative again soon. “There
is a growing expectation that the fed might be near the end
of Phase 1, at least, of this tightening cycle,” he says.
“At the same time, with energy prices flaring up again,
all-items CPI inflation might start to climb again.”

If the quest for an “honest return” sets in motion the next
leg of the gold bull market, monetary instability might
keep it in motion. “The true prerequisite for a continued
rally in the gold price is monetary disorder,” Grant
asserts. “Motive power for the 1980-99 bear market was the
lack of disorder (though there were many promising crises),
in the absence of which financial assets produced outsized

Therefore, the unfolding constitutional crisis in Europe,
which is becoming a low-level monetary crisis, may provide
ideal conditions for a sizeable gold rally.

“Constant readers know that [we have] been keeping a
bedside vigil for the international monetary system for as
long as we’ve been publishing,” Grant continues. “We’re
still at it. The arithmetic of the U.S. current account is
– as it has been for decades – adverse; noting new there.
New is the political and constitutional crisis in Europe.
It will rattle the world’s confidence in the single
currency. More than that, it could lead a remnant of the
world’s savers to reason that the euro’s problems are not
unique to the euro but inherent in managed currencies. The
dollar may yield more than a single currency, but it too,
is an uncollateralized emission of a governmental body.”

Gold, of course, is not. Gold is an expressly non-
governmental component of the earth’s crust – and a
geologically scarce component at that. This legendary
scarcity – because it precludes the possibility of
inflation – enables gold to provide an “honest return”
whenever the world’s managed currencies cannot.

“There is $1 trillion or so worth of gold in the world, of
which central banks hold half,” Grant concludes. “There is
$369 billion of gold derivatives contracts outstanding (or
was at year-end, up from $318 billion at midyear). There is
$9.6 trillion in U.S. M-3 (e.i. money supply) and the
equivalent of $8.3 trillion in euro M-3…So relatively
scarce is bullion that even a small reallocation of
monetary assets to gold from paper, a small tweaking at the
margin, could cause an inspirational pop in the gold

Did You Notice…?
By Carl Swenlin

A good measure of market participation — the number of
stocks participating in upside price moves — is the
percentage of stocks above their 200-day moving average.
DecisionPoint.com tracks this number on the major market
indexes, and in this instance we are looking at this
indicator for the S&P 600 Small-Cap Index.

Note how the indicator has been making lower highs for the
last 18 months, even as the price index has made new all-
time highs. This negative divergence is not necessarily
fatal, but it does reflect how the price index is being
supported by fewer and fewer stocks.

The price index can move higher because it is
capitalization-weighted. This allows the larger-cap stocks
in the index to carry it higher, while increasing numbers
of smaller-cap stocks begin to fade. This is not healthy,
and it is another piece of evidence that indicates that the
cyclical bull market is probably near an end.


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