In times gone by a high M3-FFR has spurred fears of inflation, thus prompting the Fed to begin hiking interest rates until a) the FFR became greater than the M3 growth rate (M3-FFR went negative), and b) the economy plunged into recession. The difference, this time around, is that the Fed not only stopped hiking rates earlier than usual, but also began aggressively cutting rates while M3-FFR was still at a high level. In other words, the Fed is doing its utmost to ensure that the M3 growth rate remains much higher than the Fed Funds Rate. Perhaps Greenspan is looking at a similar chart and is aware of the risks of letting a recession develop at a time when private debt levels are astronomically high. His solution? Encourage people to take on even more debt!
Recapping the above, the M3 growth rate minus the Fed Funds Rate is an exceptionally good predictor of economic growth. Furthermore, as noted in previous commentary, real-M2 growth is also a reliable predictor of economic growth. However, during the Q&A session following his recent testimony before Congress, Greenspan stated that he does not consider the monetary aggregates to be a useful guide to monetary policy. Hmmm...something doesn't add up here. The only reason a central bank reduces the cost of short-term money is to increase the availability of money by encouraging consumers and businesses to spend, borrow and invest. Low interest rates, in and of themselves, are not necessarily helpful (as the Bank of Japan would testify). Perhaps the Fed Head simply wished to avoid having to explain-away the explosive growth in the monetary aggregates (there is no inflation, right?) and the best way to do that was to 'play down' their usefulness as economic indicators.
The Gold Credit Expansion
Credit expansion inevitably cheapens a currency. However, the expansion of credit requires both willing lenders and willing borrowers. It doesn't matter if lenders offer extremely attractive terms to the borrowers, if the borrowers choose not to accept those terms then credit cannot expand. Similarly, a huge 'borrowing demand' will not lead to an expansion of credit unless there are lenders willing to satisfy that demand. This point is directly applicable to the gold market. Total gold loans are estimated, by reliable sources, to be 10,000 to 12,000 tonnes, more than half of which have been made in connection with gold mining company forward sales. The central banks have offered to lend gold at attractive interest rates, but without the willing borrowers - the gold producers - the volume of gold loans could never have expanded to anywhere near its current extent. The gold producers that have forward-sold large amounts of gold over the past decade have made a significant contribution to the decline in the gold price.
Until recently, the expansion of USD credit had not led to a fall in the Dollar's relative value because the growth in the investment demand for Dollars had more than offset the growth in the supply of Dollars. In the gold market, with investment demand falling, the producer-assisted expansion of gold credit has substantially increased the depth of the decline in gold's relative value. And to what end? The stock prices of the major unhedged gold producers have tended to keep pace with those of the major hedged gold producers during periods of gold price weakness and have dramatically out-performed during the rare periods of gold price strength. From a shareholder's perspective it seems that the forward selling of gold limits the upside (in the stock price), but is not effective in minimising the downside.
Gold and the Stock Market
Below are updated versions of charts included in previous commentary at TSI. The top chart shows the S&P500/gold ratio, or the number of ounces of gold it takes to buy the S&P500 Index. This ratio peaked in July 1999 and has been trending lower since mid-2000. The bottom chart shows the S&P500/XAU ratio and our long-term target of 10:1 for this ratio (we expect the ratio to reach 10:1 within 2 years). Although both ratios are moving in the right direction (down), most of the work to date has been done by the S&P500. However, if we have correctly identified a trend towards higher inflation then we should soon see good absolute performance by gold and gold stocks (rather than just good relative performance).
Steve Saville
Hong Kong
5 March 2001
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