Why You Should Ignore the Gold Sell Off

On July 13, gold was still around $1,340 per ounce. Since last Monday, gold has suffered a big drop, falling as low as $1,293 in a few days. Many blame the decline on hawkish comments from the Fed’s Janet Yellen, who recently suggested the Fed could raise interest rates. “Higher interest rates would encourage investors to switch to assets that, unlike gold, pay interest,” said the news service Reuters.

Following Thursday’s news from the Ukraine, gold has rebounded from its low, but remains under $1,320 as of July 18. Rick Rule, Chairman of Sprott US Holdings Inc., recently said gold could fall back another 10% as a normal event in this market. I asked him whether this week’s step down had altered his views on gold for 2014.

“I am very encouraged by the market action that we are seeing in both gold, and the gold equities.”

Does the recent drop in the gold price affect your outlook for gold in 2014?

“No, not at all, Henry. You will recall that in our last interview, I suggested that gold and gold equities would grind higher after reaching a bottom, I believe, in July of last year. That is precisely what’s happening. We’re seeing higher highs and higher lows, but every new high requires a subsequent consolidation. You’ll be up 10 or 12%, then off 8 or 9%. The ‘backing and filling’ that we are seeing right now is completely consistent with the behavior that we would expect to see coming out of a bear market bottom into a gradual recovery.

“I think this market is in good shape. It’s healthy. These ‘j-curve’ advances are followed by appropriate declines on the backside. I am very encouraged by the market action that we are seeing in both gold, and the gold equities.”

What do you make of Fed Chairman Janet Yellen’s recent comments regarding raising interest rates? Are higher interest rates plausible?

“What Janet Yellen said was that the recovery was tepid at best – if we have a recovery at all. The political narrative dictates that low interest rates are needed in order to help the economy.

“My own belief is that interest rates will remain low in the next 18 months or 2 years, but for a different set of reasons. There isn’t much private demand for loans, even at this low interest rate. But there is an implicit transfer of wealth from savers, who benefit from higher interest rates, to spenders. It’s the spenders who are more numerous, which means that the government will look out for the spenders at the expense of the savers.

“Secondly, the extraordinary levels of Federal, State, and local debts would be difficult to service at higher interest rates. As a result, I think that the Fed will continue to do whatever it can in order to keep interest rates constrained for as long as possible. As long as the demand for debt from the private sector remains low – in other words, until the economy recovers — I believe you will see artificially low interest rates.”

Recent reports show that big companies, like IBM, are probably issuing debt for the sole purpose of buying back their own shares. What do you make of this behavior? Is this the beginning of the end for low interest rates?

“Actually, I don’t think so, because they don’t need to borrow this money for their basic business. The biggest corporations in the United States have good balance sheets and are generating fairly substantial free cash flow. There is nowhere for them to re-deploy the money in their own businesses, because the economy is expanding slowly.

“At these interest rates – particularly if these companies can lock in these interest rates for long periods of time – debt is a cheaper form of capital than equity. In a slowly growing economy, the only way that these companies can increase earnings per share is to reduce the number of shares.

“What they are doing – buying back their own stock with borrowed money – is a normal response to the Fed’s low interest rates. Right now, debt is much cheaper than equity in the long term.

“…the way I look at this nearly ‘free’ capital is ultimately good for gold.”

“Of course, there is a downside. Companies like IBM are weakening their balance sheets, which were real fortresses against potential problems in the economy. When everyone does this, you are replacing more and more equity with debt. You are making the economy as a whole much more vulnerable going forward. That will become a concern for these companies in 18 months or two years from now.”

If it is good for big companies, why not for everyone else? Do you think average investors should also try to benefit from these record low interest rates?

“In fact, I do. For an investor who has a stable financial situation, a 30-year fixed-rate mortgage for a house where they intend to live will probably begin to feel like free money once we are 3, 5, or maybe 10 years down the line. If you have the ability to borrow long-term capital at today’s rates, and are able to service the debt – in other words, don’t abuse it – this is probably a once-in-a-lifetime opportunity. After real inflation, the costs of this capital over the long term will likely be negative. That’s very attractive!”

What do continued low interest rates mean for gold going forward?

“Ultimately, it’s probably pretty good for gold. Right now, you are seeing gold being crowded out, because the returns from other assets such as stocks look more attractive.

“But the way I look at this nearly ‘free’ capital is ultimately good for gold. It weakens the medium of exchange, the US dollar, in which gold is denominated.”

Regards,

Henry Bonner
for The Daily Reckoning

Ed. Note: If you didn’t buy into gold back in 2001 when it hovered around $300 per ounce, don’t worry. There is still plenty of upside for the yellow metal. And subscribers of the FREE Daily Resource Hunter email edition – where this interview was prominently featured – have unique access to a host of great reports on gold and other precious metals – including the very popular 5 Best Ways to Invest in Gold report. To gain access for yourself, be sure to sign up for the Daily Resource Hunter, for FREE, right here.

The Daily Reckoning