Most discussions about the effects of the Y2K computer bug on the financial markets deal with potential problems occurring on 1st January 2000 and thereafter. However, the stock market discounts the future, which is why a bull market invariably ends when the short term outlook for earnings growth appears to be at its brightest and commences amidst the worst stages of an economic decline. This discounting mechanism, applied to the Y2K phenomenon, may mean that the negative impact of Y2K on the stock market will be felt prior to 1/1/00. If this is the case and assuming that the actual effects of the Millennium Bug do not exceed the worst projections, the stock market may experience an enormous relief rally during the first half of next year.

As we make our way towards the Year 2000 transition we will no doubt observe a growing level of fear surrounding the potential effects of the computer bug. Both the debt and equity markets will react to this change in investor psychology as an increased perception of risk is priced into the markets. In the debt market this increased perception of risk will be reflected in widening credit spreads (a spread is the interest rate differential between US Treasury debt, considered to represent zero risk, and other forms of debt).

Y2K will almost certainly accentuate the current trend of increasing spreads in the credit markets. People will demand a higher rate of return on the money they lend because, in their estimation, they will be taking on a greater risk. The Y2K risk, for most investors, is essentially a fear of the unknown. The timing of the event is known, but the actual outcome could be anything from a minor disruption to a total disaster depending on whose assessment you happen to be reading. The closer we get to Year 2000 the greater will be the fear in the market, causing credit spreads to widen even further and liquidity to disappear. Accordingly, we are now seeing a huge push by companies and financial institutions to bring their debt offerings to market as soon as possible. This is only happening for one reason – those who wish to sell their debt believe that interest rates will be higher in the future than they are today. The expectation is that higher interest rates will result from both an increase in the benchmark rate due to a Fed tightening and an increase in risk premiums (credit spreads).

Sky-high price/earnings ratios make the US stock market extremely vulnerable to rising interest rates. At this stage the market doesn't really believe that higher rates are here to stay, and is therefore in a state of denial. However, another hike in official interest rates and/or further increases in risk premiums will effectively inject a strong dose of reality into the market.

An increase in credit spreads is also likely to affect the gold market. Gold interest rates have risen substantially of late, a phenomenon for which several explanations have been put forward. The explanations generally revolve around reduced lending supply (central banks possibly limiting their lending activities in preparation for future sales) or increased borrowing demand (producers rushing to forward sell in order to lock in these great prices). However Normandy Mining, in its 4th Quarter Report released last week, may have inadvertently provided a clue as to what is really happening with gold interest rates.

Normandy Mining is Australia's largest gold miner and one of the world's largest gold hedgers (it currently has about 12M oz hedged through forward contracts and put options, including the hedging of subsidiary and associate companies). Its quarterly reports always include a table of gold hedging positions. Printed below this table on the latest report was the following note regarding the exercise prices on its hedges: "Exercise prices are before hedge fees. From 1 July 1999, exercise prices will be net of actual or estimated fees - reflecting the potential for increased gold lease rates ahead of possible Year 2000 issues". In other words, here is one of the world's largest gold mining companies changing the way it has always reported the exercise prices on its hedges because of potential Y2K issues.

For the uninitiated, implicit within every gold forward sale price is an assumed gold lease rate. The forward sale price reported by a gold mining company is determined based on the interest rate differential (spread) between gold and US Treasuries. A rise in gold interest (lease) rates relative to US Treasury interest rates will reduce the effective exercise price on the forward sales. This not only has the effect of discouraging further hedging, but will reduce the profitability of existing forward sales that have been undertaken based on a floating gold lease rate. Many mining companies have chosen not to fix the gold lease rate associated with their forward sales, probably due to the added cost of doing so and complacency regarding the continuation of the low lease rate environment. It is likely that these companies have assumed a gold lease rate of around 1.5% p.a. in calculating the realizable price on their forward sales. Should gold lease rates remain at their current level of around 3%, or increase further as Y2K approaches, then we may see producers rush to buy back their forward sales rather than sit back and watch as the impressive mark to market profits on their hedge books evaporate. If gold producers are prompted to become net buyers, the impact on the gold price could be substantial.

There is currently no evidence that the gold price has bottomed, but the extremely over-sold nature of this market and the immense short position will certainly provide at least a technical bounce during the next 3 months. Due to the crushing effect of the on-going bear market on the gold mining industry, in the absence of relatively high gold lease rates some producers would look to any rally as an opportunity to engage in further hedging. This producer selling would potentially cap the upside for the gold price. Rising gold interest rates, however, would remove gold producers as an obstacle to higher prices.

The majority of investors are still quite complacent regarding the Y2K issue, just as they are unconcerned about the extremely high prices being paid for stocks relative to the earnings growth of the underlying businesses. However, at some time later this year as the illusion of perpetual 20% per annum stock market gains is being severely tested, fear relating to Y2K will be mounting. Even the most optimistic of punters, those who believe the computer bug will have absolutely no impact on the economy and the financial markets, will be tempted to take some money off the table – just in case. The selling will likely feed on itself, as each decline prompts even more selling and increases the general level of consternation. In parallel with all this we will no doubt see the proliferation of articles regarding Y2K in the mainstream press, with some articles describing horrific 'end of world' scenarios.

As far as the gold market is concerned, fear revolving around Y2K and a declining stock market will certainly prompt some members of the general public to buy more gold coins. However, this increase in demand is not likely to be significant compared to the total above ground supply of gold. It is also not particularly bullish, since the man on the street is never the first to recognize a new investment trend. The greatest positive impact of Y2K on the gold price will most likely stem from increasing gold interest rates that will remove the incentive for gold mining companies to forward sell and reduce the feasibility of the gold carry trade.

The bottom line is, the upcoming (or on-going) stock market correction will be more severe than it otherwise would be in the absence of such an extraordinary event. However, if fear reaches extreme levels this year then it is just possible that the dawn of the new Millennium could bring a feeling of profound relief that ignites one of the greatest buying binges in history. In the gold market these forces would probably produce opposite reactions, that is, a rally into year-end followed by a sell-off in early 2000 as risk premiums return to more normal levels.

Milhouse
Hong Kong
30 July 1999

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