May 24, 2005
ONE METAL, TWO VISIONS
It's never been easy being a gold bug, but now it's getting complicated.
Such is life for divining financial trends in the 21st century, or so it appeared at the New York Institutional Gold Conference, which ended a two-day run today at the New York Marquis Marriott. Surveying this confab of all things gold, CS was able to discern at least two distinct shades of optimism among those who think the metal's going higher still in the years ahead. The first is what we'd call the traditional gold bug, a creature marked by an unwavering belief that inflation is on the rise, and so then is the price of gold, which closed today at roughly $418 an ounce, or about $20 below where it closed at 2004's end.
The second, and more innovative school of thought among the gold bugs could hardly be more different in citing the catalysts that will elevate the price of the metal. This faction predicts that deflation is coming, courtesy of the mounting pile of debt accumulated by both governments and individuals. Yes, we've been there, done that, and listened to Bernanke's monetary threats. But what's old is new again.
In any case, wouldn't deflation hinder the price of gold? Not at all, says deflationary wing of the precious metal club.
Despite the disparate visions of the future, both sides of the aisle in the church of gold are united in a vision of higher gold prices. Timing is necessarily vague, of course, but to talk to a representative on either side is to receive rhetorical injections of supreme confidence about the path of least resistance for the precious metal. As many have noted before, it's quasi religious. But is it a sin to believe in something other than inflation from a gold bug's view of the world?
Perhaps, but in so observing the opposing factions cheering the metal, it necessarily follows that one side will be wrong. Deciding which one, of course, is the trick. We say "trick" because those predicting higher inflation have had the monetary smoking guns on their side in recent years, i.e., a money supply advancing at a rate above and beyond the obvious and immediate needs of the economy. But the tide may be turning on the monetary front, raising the question of what's the economic impact of a reversal of the monetary fortunes after erring on the opposite extreme for several years?
Deflation, of course, say some gold bugs, albeit a minority within a minority. With that in mind, we cite the recent downturn in the annual rate of increase in the money supply. Consider that M2 money supply advanced at a mere 1.7% on a seasonally adjusted annual basis for the three month through the end of last month, or down sharply from the 4.1% for the 12 months through April 2005, according to the Federal Reserve. The slowdown is even more striking in the narrower measure of money supply known as M1, which actually contracted its pace of change for the three months through April.
A new smoking gun? Or just a technical correction to be ignored?
In fact, it's not money supply that worries the gold bugs, some of whom expect deflation. Rather, it's debt. Indeed, a gold bug who warns of deflation is one Jay Taylor, who publishes the J. Taylor's Gold and Technology Stocks newsletter. Taylor believes that the rising pile of debt, and a presumed inability to pay it off, will bring on deflation. "It is remarkable to me that with only a slight slowing down of global U.S. dollar liquidity we are already seeing warning signs of illiquidity that could lead to a deflationary collapse," Taylor writes via an article dated today in HoweStreet.com. Debt is the raw material from which fiat money is manufactured. "With each new money creation episode by policy makers aimed at avoiding deflation, they plant the seeds of an even deeper recession and a more dangerous financial framework," namely, a deflationary contraction, he predicts.
The bond market seems to agree with this line of thinking, to a point. The yield on the 10-year Treasury was near to testing the year's lows on yield. The benchmark government bond yielded just five basis points over the 4.0% market, the least since early February. In high inflation's coming, you'd never know it by watching the bond market.
The belief that deflation will ultimately prevail explains the recent weakness in gold, Taylor continues. "This is true in my view because 99% of gold investment demand comes from people who think gold is a great asset to own during inflation but a terrible one to own in deflation." Being in the remaining one percent of the gold-bug population puts Taylor in the position of both believing in the prospects for gold and predicting a fall in prices generally. A re-education of gold bugs may be coming, but in the meantime there'll be a lot of head scratching: "And so in the early stages of the deflationary process, until people begin to realize gold is money, the baby is being thrown out with the bath water so to speak."
Gold, in short, is only in a temporary downturn. Among Taylor's sources for his deflationary outlook are Bob Hoye, a strategist who publishes his forecasts from the perch of Institutional Advisors. In an interview in February, Hoye explained in Taylor's newsletter that deflation would be the byproduct of rising debt that triggers an economic collapse and a Fed that for various reasons won't be able to continue to engineer rising prices. Hoye explains: "…once the contraction starts, I suggest that it overwhelms the ability of the Fed to pursue its portion of credit creation. I’m not saying that the Fed is going to suddenly tighten. No bloody way—not willingly! But the whole system is going to tighten as all the leveraged 'liquidity' disappears."
What unfolds when and if the liquidity disappears is, of course, open to debate. On that score, there's still time to consider the matter with the assumption that the end is not yet here. Using sales of existing homes as a proxy, liquidity is alive and well in some corners, according to today's news from the National Association of Realtors. An all-time record of existing home sales was reached last month, the group notes. Single-family home sales rose 4.5% to a seasonally adjusted 6.28 million. Could there be a connection with the fact that the median single-family home price was $203,800 last month, up 15% from 12 months previous?
Is this how deflation starts? Or is it a sign of inflation? Even the gold bugs can't agree.
In any case, more than a few pundits of the financial scene remind that the Fed's printing presses can produce dollars in virtually unlimited quantity. To the extent that inflation is a monetary phenomenon, inflation is always just around the central bank's corner.
But Hoye distinguishes between the money supply and real money. " It’s a misnomer to call M-1, M-2, and M-3 money. And so once the prices of the assets being speculated turn down, then the margin clerk takes over." In short, "Credit is taken on because of soaring asset prices. As the prices stop going up, you are left with the debt."
When the bubble pops, the margin calls come and investors sell whatever they can. Money, in the form of gold, will increase in value as it represents pure wealth, or so the argument goes. In a deflation, Doug Casey of Casey Research counseled a few years back, "gold would soar in serious deflation." Why? Because gold is a device for conserving capital when all else is bleeding wealth, he opines. In that context, gold's value will rise in a relative sense by protecting wealth.
Then again, one larger-than-usual bubble known as the stock market popped a few years back. The result, so far, is higher inflation; marginally so, but higher nonetheless. Gold prices have climbed during that stretch as well. In fact, a gold bug of the inflationary line of thinking recently felt that the deflationistas had to be reminded again of what makes gold price tick. Steve Saville of Speculative-investor.com via SafeHaven.com writes on April 19: "...when gold was the official form of money it was a hedge against deflation whereas under the current monetary system [which is to say fiat money] it is a hedge against inflation. We think additional inflation is by far the most likely outcome over the coming 1-5 years so it follows that we are long-term bulls on gold."
But the deflationistas aren't so easily convinced, and in fact they worry about the next big collapse. Speaking of which, the leading candidate for the next bubble bursting is arguably real estate. Would a sharp correction in housing prices be any more likely to bring on deflation? If so, what would be the implications for gold? Alas, in a sign of the times, consensus among the gold bugs has become elusive.
Posted by jp at May 24, 2005 8:41 PM
Given we are so far into a massive inflation of money which is widely unrecognized as such (it is a fact, that multiplication of the money supply didnt disappear) the odds of gold suddenly 'getting it' and responding to inflation seem misplaced. Same goes for talking about golds recent move removed from the dollars large tumble. It is also bogus to speak of golds previous record in deflations as back then, gold was by definition money, so as money became more valuable, (deflation), wow, so did gold. It is a truism. That link, sadly, no longer holds and I fear in a deflation the Fed's ability to counteract any loss of confidence in ever appreciating assets of many kinds will be less forceful than previously as they have outsourced the ability to print money. Plus, we are starting with absolute rates at such a low absolute base, with vast debt/income ratios... the die hard gold bugs will point to Bernanke etc and yes the Fed could just double money supply again but unless there is the willingness to take on debt the fractional reserve banking system will struggle. Witness Japan. We like to look for excuses as to Japan's special case, but face it, rates are effectively zero, they have real land shortage issues not like the ones we use in the UK to justify ever higher prices as a sine qua non and prices have been falling for 15 years (OK, it looks like at last they might be bottoming but hey, a Japanese buying gold since 1989 in Yen terms would be down 10%, not bad but better to buy bonds!
Posted by: Jonathan at May 25, 2005 6:25 AM
Another good article, James. I simply think gold is though of way too highly as a store of value. If deflation hits in a big way and the world shies away from fiat currency, gold may well do fine, but I'm taking something that actually gets used... like platinum, or geez, even silver.
Posted by: The Assetman at May 24, 2005 11:05 PM