To answer this question it is important to understand the major drivers for investments. In my previous articles the main conclusion has been that monetary aggregates - as shown in the next graphs - are the main drivers for economic activity. Thus, these aggregates are also the drivers for profits and higher stock prices as more money is the fuel for any economy.
Monetary aggregates are also the main drivers for commodities and - as shown in this article - also the cause for any movements in gold.
There has been an unprecedent increase of M3 money supply over the latest decade. This has made many analysts to believe that M3 growth will eventually lead to a higher gold price and higher inflation. Nevertheless, the following chart shows no positive correlation between M3 money supply and the gold price. In the contrary, there exists a strong inverse correlation. M3 growth leads to a lower gold price and is therefore deflationary and not inflationary. This has been once again proven by the steady rise of gold exactly when M3 growth declined (please read my previous articles).
On the other side, there is a strong positive correlation between gold and M1 growth. M1 represents cash or cash deposits and can be therefore seen as the real indicator for more money in the economic system. M1 is a very strong leading indicator for a rise in the gold price. The peaks in M1 just happened one or two years before the peak in the gold price, which in turn has been leading other commodities as well as interest rates.
As the distinction between M1 (=cash) and M3 (=long term commitments or paper assets ) is very important to understand, it is interesting to see the interaction of M1 and M3 as a basis for a monetary policy.
As shown in the third chart, high M3 growth is consistent with an asset bubble as it happened from 1980 to around 1992 (Reagonomics). As asset bubbles slow down economic activity, the US Central Bank had to step in and print more cash (=M1) in order to compensate for slower M3 money supply. Over the eighties and beginning nineties the US FED has done so by increasing M1 supply substantially. This process represents the monetizing of the previous asset bubble, which Central Banks do not like to do as this is followed by a period of high inflation and slow growth.
As it can be seen in the last chart in 1994 a new asset bubble started to emerge and the US FED could slow down printing cash. So, basically the FED has been extremely restrictive during the nineties. There is no way to blame the US for printing cash in the nineties. The high growth of M3 kept the US economy going - virtually inflation free. Nevertheless, the asset bubble started to deflate in 2001 and the FED had to step in and increase M1 money supply once again. This is the major reason for the latest move of gold and also for other commodities.
The chart reveals also other interesting details. In 2004 interest rates are nearly in the same constellation as in 1994. So, many analyst expect an immediate interest rate hike just like it has been in 1994. Nevertheless, the monetary environment today is completely different than in 1994. In 1994 we have been basically at the beginning of a new asset bubble and at the end of an huge monetizing period. Today, the latest asset bubble has barely started to deflate and we are still at the beginning of the monetization period of this asset bubble. Despite many press comments about higher short interests, it is very unlikely that we see a sustained rise of FED Funds over the next years. Higher long term interest rates triggered by inflation fears will even further depress M3 monetary growth. This will for sure slow down the US economy and force the FED to open the monetization gap (difference between M1 and M3 growth) even further. Higher M1 growth will very likely lead to much higher gold and commodity prices over the course of the year after the current correction is completed.
It is now very interesting to see the further monetary picture to develop. As it takes usually very long for an asset bubble to deflate (Japan !!), it is likely that the current environment for low FED Funds persists much longer as many observers can think of. Should the FED raise interest rates anyway, the situation would become actually much worse as then long term interests rise higher and depress M3 growth even more. The following economic slowdown would then require a much higher monetary easing in the next years.
I look forward to receiving your comments.
Regards
Heinrich Leopold
hgleopold@yahoo.com
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.