The following are extracts from recent commentary that appeared at The Speculative Investor web site.

Gold Stocks versus Real Interest Rates

Gold is a hedge against inflation or, more accurately, a hedge against the loss of confidence in a fiat currency that usually occurs as a result of inflation. Gold stocks are leveraged plays on the gold price or, in other words, leveraged hedges against inflation. It therefore makes intuitive sense that the XAU tends to rally sharply at those times when the Fed is perceived to have lost control of the inflation bogey.

The below chart shows the XAU (in orange) and the difference between the Fed Funds Rate and the Median CPI growth rate (in blue). (The Median CPI is a better and less-volatile measure of the underlying trend in consumer prices than is the CPI because any outlying values are removed from its monthly calculation.) The blue line therefore represents the real, or inflation-adjusted, Fed Funds Rate (FFR).

The XAU has, in the past, tended to move lower with the real FFR up to the point when the market realises that the Fed has taken interest rates too low relative to the CPI growth rate. At that 'point of realisation', the XAU explodes higher. In 1986, the point of realisation occurred when the real FFR dropped to around 1% (point A on the chart). In 1992 it occurred when the real FFR dropped to -1% (point B on the chart). Sometime after gold and other inflation hedges explode higher, the Fed starts hiking rates until the real FFR moves up to the point where the inflation hedges lose their appeal.

At the current time the real FFR is around 0%, so we are in the right ballpark as far as an explosive up-move in gold stocks is concerned.

Note that the relationship between the XAU and the real FFR did not follow its normal pattern between 1997 and 2000. During this period the real FFR drifted higher, courtesy of a flat or falling CPI. A sharp rise in the CPI would normally have resulted from the huge increase in the supply of money that occurred between 1997 and 2000, but in this case it didn't. The main reason it didn't, and the entire basis for the "New Era" myth that still has many adherents to this day, was the phenomenal growth in the current account deficit.

The late economist Robert Triffin explained that there are two ways in which an economy can adjust to excess demand caused by excess financing (money supply growth). An increase in domestic prices is one way. Under certain conditions, however, a current account deficit may "constitute the main channel of adjustment to inflationary pressures and reduce correspondingly the extent of domestic price increases." Triffin also explained that as long as the excess demand persisted, any measures that successfully reduced the current account deficit would boost domestic prices, and any measures that successfully reduced the domestic price level would boost the current account deficit. Only the removal of the excess demand (the excess money) could solve both problems. This is why we watch the money supply growth rate so closely - as long as the money supply continues to grow at a fast pace then either: a) the current account deficit will continue to grow until it eventually causes a sharp downward adjustment in the Dollar's exchange rate and a consequential sharp rise in the gold price, or b) domestic prices will eventually experience a substantial rise, thus boosting inflation hedges such as gold and gold stocks. This is also why the US monetary authorities are loathe to do anything to specifically address the burgeoning current account deficit - this deficit is the key to maintaining a reasonably stable price level in the face of explosive money-supply growth.

Bond Market Update

We turned medium-term bearish on bonds in early-January and remain so, although we have turned short-term bullish on a couple of occasions (most recently near the bottom in late-May) in the anticipation of tradable rallies from oversold extremes.

The general weakness in the T-Bond price over the past 6 months is a result of aggressive 'easing' by the Fed and the explosion in the money supply growth rate. With new money being created at a rapid rate and with the Fed forcing short-term rates lower, the market rightly fears a reduction in the purchasing power of the Dollar and has, as a result, moved long-term interest rates higher. The continued strength of the US$ relative to other national currencies has, however, prevented bonds from falling completely out of bed.

A strong Dollar underpins long-term bond prices because it helps suppress the symptoms of inflation and can even create the illusion of deflation. True deflation is a contraction in the total supply of money, but one of the symptoms of deflation - falling prices - can be manufactured by an excessively-strong Dollar. A Dollar that is very strong relative to the currencies of the US' major trading partners turns the world into a giant bargain-basement shopping mall for US consumers and businesses. Cheap (in US$ terms) foreign imports also severely limit the prices that can be charged by US-based manufacturers/retailers. As long as increases in the Dollar's foreign exchange value are able to offset the effects of the burgeoning supply of US Dollars, it will be possible for long-term interest rates to remain below 6%.

In our view, the only way that long-term interest rates will fall below their March 2001 low will be if the Dollar Index rallies by at least 10% from its current already-elevated level. Although a bit more strength in the Dollar Index is possible in the very short-term, we see a major Dollar rally as extremely unlikely and consider the Dollar Index to be a short-sale candidate above 120.

Steve Saville
Hong Kong

28 June 2001

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