Gold Market Update

March 3, 2001

Last week gold mining shares outperformed all other Dow Jones industry groups. Investors apparently may be beginning to recognize the wisdom and value of gold diversification. Gold, of course, is a default-free (counter-party risk-free) and currency risk-free monetary asset.

The wave of negative market sentiment which took the price of gold from $ 275 an ounce on December 27th to $ 255 an ounce (its 1999 low) on February 15th may be turning. This sentiment was reinforced by the fear of slowing Indian demand due to the Gujarat earthquake and was reflected by a record "large speculator" CFTC Traders' Commitments net short position of 207 tons on February 20th. The gold price closed at $ 260.90 an ounce last Friday, up 2.3% from the low. Signs of possible new trends were a fall in the Dow Jones Industrial Average to gold ratio from 42.7 on February 15 to 40.0 last Friday, a rise in the gold/silver ratio from 54.4 on January 26 to 58.9 on Friday and an increase in the percent of the gold price to the CRB Futures Index from 1.15% on February 20 to 1.18% on Friday.

The prices of gold mining shares have recently behaved better than gold, another encouraging sign of a turn. They rose sharply from the November lows to the mid-December highs. In the subsequent correction, the gold mining indices' mid-February lows were approximately 10% above their November lows while the price of gold was 3.8% below its November low. Recently, the Philadelphia Gold/Silver stock index (XAU) jumped 9.6% from a low of 45.82 on February 14 to 50.23 last Friday.

A significant development in the gold market has been the rise in gold lease rates. The 3 month rate has climbed from approximately 0.8% at the end of January to 1.85% last Friday. The 12-month rate is up from 1.35% just a week ago to 1.78% on Friday. The consequences of higher gold lease rates and declining short-term interest rates have been lower contango rates on futures contracts. This makes hedging less interesting. According to usually reliable sources, the tightness in liquidity arises from maturing central bank loans not being renewed. Perhaps central banks are now becoming more interested in protecting the value of their national gold reserves than on the small extra income from gold loans which subsidizes the speculators.

Hopes that the second Fed cut in short-term interest rates at the end of January would help market sentiment have faded in the face of weaker earnings expectations and other disappointing developments. Inflationary pressures are still high (January CPI up 3.7% year-to-year, PPI up 4.8%). The specter of stagflation is back. The US 2000 trade deficit was a record $ 369.7 billion. Last Friday a senior Intel executive warned that the telecom industry could be heading for bankruptcy because of the cost of and possible delay in introducing third generation mobile phones. Telecom debt expanded over $ 300 billion in the last three years. Moody's Investors Service predicted the slowing U. S. economy faces a surge in corporate bond defaults this year that will not peak until 2002.

Will lower short-term interest rates in the future reverse the current pronounced slowing in the growth of aggregate demand? Will future consumer borrowing be large enough to offset normal payments on installment and mortgage debt and to raise the growth in aggregate demand to potential capacity? Will households continue to dissave? Much past US growth was based on "easy money" and the buildup of debt which grew faster than the economy. Business and household debt climbed from $ 3.4 trillion (105% of GDP) in 1982 and $ 7.7 trillion (121% of GDP) in 1992 to $ 13.4 trillion (134% of GDP) on September 30, 2000. Is this rate of debt growth sustainable? If the answers to these questions are negative, a period of acute financial stress and a "hard landing" may not be ruled out.

A recent World Gold Council study of the behavior of various asset classes during both stress and non-stress periods to determine the optimal mix for "efficient" portfolios concluded that a portfolio for optimal performance during stress periods would contain significant amounts of gold and fixed income securities. A portfolio for a stress environment could contain 46% T-bills, 16% long-term government bonds and 29% gold.

One cubic foot of gold weighs more than half a ton (1,306 pounds).

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