Investment in the precious metal market requires a deep knowledge on the interrelated forces influencing the markets for precious metals. Flat and 'common sense' conclusions will lead to serious misjudgements. Just as an example, the US current account is currently not the main driver for the US dollar, which influences the precious metal prices. So, it has been a devastating strategy to expect a lower US dollar and higher precious metal prices due to the high US current account deficit.In the following picture I have depicted a broad overview of the interrelated forces, driving precious metal markets.
In the above picture only physical demand supports currently precious metal prices. No wonder the prices are so depressed.
In this network of inter- and correlated factors we have selected three main factors, which drive the precious metal market.
From these three we have created a gold timing indicator.
The overwhelming influence on precious metal prices derives from Federal Funds as depicted in the next picture.
It strongly suggests a good correlation between Federal Funds and the gold price, mainly from 1990 to 1997. Nevertheless, from 1997 on, the leverage changed as a small decline in the interest rates triggered a huge decline in the gold price. This is very likely due to central bank gold sales. Nonetheless gold still predicts interest rate rises and declines as we could see that the sudden rise in gold prices in 1999 (Washington Accord) predicted the 2000 interest rises.
It is now overlooked by politicians that gold not only predicts higher interest rates and inflation. It also predicts lower interest rates and deflation. Given the above chart, gold predicts a scenario consistent with very low interest rates and deflation/depression in the next future. As we will see later in this article, this provides a very favourable framework for future rises in the precious metal market.
Low Federal Funds rates trigger high M1 monetary growth. M1 represents real new cash in the monetary system. This is the real inflationary threat for a currency.
In order to find a leading indicator for precious metal prices it is important to indicate the growth for real new cash in the monetary system. Although M1 could serve as this indicator, M1 is somewhat distorted by the growth of M3 and M2 which represents future liabilities in the monetary system. M2 and M3 are basically deflationary indicators.
An excellent indicator for precious metal prices for the above reason is the difference in growth rates between M1 and M2 as it is depicted in the next picture. This is a very accurate indicator for the creation of real cash in the currency system. A high M1-M2 indicates a high growth rate of M1 versus long term money M2.
Within a time lag of one to two years, this indicator has a very high accuracy. This indicator has started to turn around very quickly in the latest few months and indicates much higher precious metal prices within the next two years.
Mining supply is rather stable as mining output cannot be changed abruptly due to high investment costs in new capacity. Nevertheless, supply is very strongly influenced by lending and leasing activities in the precious metal markets. These activities are strongly influenced by leasing rates, which in turn correlate strongly with Fed Funds.
The above picture shows that the latest surge in gold prices occurred in early 1993 when Fed Funds (and net leasing margins) were at record lows. As we will reach this point soon, we also can expect a gold rise within the next two years.
The world wide competitor for precious metals as reserve asset is the US dollar. There is an inverse correlation between the US dollar and precious metal prices. The question now is :What is the main driver for the US dollar? In our judgement, the main driving force for the US dollar is currently the US-Japan interest spread.
The long US-Japan interest spread is the difference between long term US and Japanese interest rates, which stands now at a rate of about 4%. US bonds yield around 5.5 % and Japanese long bonds yield 1.5 % (4% difference). This makes it very attractive for Japanese banks and insurers to borrow money in Japan at very low rates and buy US bonds at a much higher yield. As enormous sums flow due to this reason into the US, the US dollar is very strong despite the high current account deficit. In that context, Japan has exported the boom to the US, which is mainly based on high M3 growth (bonds and other long term liabilities). This mechanism will almost surely lead to a long term bust in the US economy just like we have seen it for Japan. This observation is also strongly supported by the currently very deep gold price, which predicts very low inflation and interest rates in US dollar denominated economies.
The US-Japanese relationship is very special as Japan has a high trade surplus with the US. This is the only reason Japan can maintain a reasonable strong currency despite very low interest rates. Nevertheless, as the Japanese trade surplus declines dramatically, there are now two options: Japan has to sell dollars from its huge reserves (more than 300 bn dollars) to support its currency or let drop the Japanese Yen, which will trigger higher interest rates in Japan. In both cases the US dollar will weaken substantially due to lower demand from Japan. This trend has already started in the latest few weeks.
Gold Timing Indicator
Many readers of my articles have asked me about when to step into the gold market. For this reason we have created a Gold Timing Indicator (GTI) which comprises three components:
This indicator has improved substantially over the latest twelve months. Risk takers can already step into the precious metal markets. Now, the opportunities are excellent. More risk adverse investors should wait until this indicator turns decisively positive. This could happen in the next half year.
I look forward to receiving your comments and good luck for your investments.
Dr. Heinrich Leopold
18 August 2001
Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.