Gold Market Update

February 21, 2002

Following six days of steady advances gold reached a closing high of $303.50 an ounce on February 8th. Resistance and profit taking set in, and gold declined moderately to $299 an ounce on Friday, still up 6% for the month to date. Gold mining shares as measured by the XAU index are up 9.9% this month and23.6% year to date. They are now ranked the number one performing industry group by Barron's so far this year.

Gold trading activity and open interest rose with the gold price but were still far below previous records. In Japan gold trading has been hectic with volume well above New York's, anecdotal evidence suggests that retail demand in Japan may be exceeding the high levels of late last year.

In our January 21st report we equated the monetary value of gold with the quality of paper money and confidence in credit instruments denominated in that paper. Since then it seems there are almost daily reports of another corporation suspected of irregular accounting practices. Even IBM has not been spared. The subterfuges have not been limited to the United States as two of Europe's telecom titans' as well a media giant's accounting have been found wanting when unrevealed debts were exposed.

The Financial Times was prescient when it wrote in December: "The Enron disaster is the kind of corporate collapse that often accompanies recessions and bear markets. It would be a surprise if Enron was an isolated case". To paraphrase, recession reveals what accounting conceals. The Financial Times may be proven prescient again by suggesting in early February that "the Enron report should be read for what it tells not only of a failed company but of an era that may not yet have ended".

All of this shady accounting likely means that corporate debt is even higher than the 48% of GDP reported by the Federal Reserve. This combined with the largest decline in corporate earnings since the 1930's means that the quality of corporate debt is rapidly deteriorating. Reports of plunging availability of the commercial paper market confirm the weakening financial trend. The banks turn may be next as they are increasingly entreated to honor their promised lines of credit ala the 14.5 billion granted to Tyco and $4.5 billion to Qwest. Banks contingent lines of credit now total an estimated $5 trillion, roughly equal to stated bank credit outstanding. Should the banks invoke "major condition changes" to elude debtors general credit conditions would further disintegrate as many borrowers would be either frozen out of the market or be forced to refund short-term debt at oppressive rates, further lessening the prospects for economic recovery.

All this says nothing about the risk of derivatives, heavily concentrated in the vaults of several of the worlds largest banks, or of risks inherent in securitized loans and more recently of unfathomable derivative forms of credit insurance in the hands of both banks and insurance companies. Moody's has just reaffirmed J.P. Morgan's Aa3 credit rating, but its future rating depends on Morgan's performance relative to its peers. Moody's is marking on the curve, always a dangerous practice.

Corporate and bank credit quality is not the only determinant of the gold price. Abusing or even tinkering with paper money is just as important. Argentina's injudicious adoption of a currency board and then its dual currency system may lead to the peso's oblivion. We will be watching the peso as well as the Bolivar of Venezuela, a country that is oil-rich but cash-poor.

Although the currency board concept has been shaken Hong Kong and its currency board remain afloat, but China and Korea have already warned Japan of monetary retaliation if Japan continues to depreciate the yen. Some studies conclude that 200 yen to the dollar may be needed to get Japan out of its economic rut. China would be sure to follow long before that, as would Hong Kong despite huge currency reserves. Four years ago Alan Greenspan warned that in a sliding economy: "A currency lock would be difficult to maintain irrespective of foreign exchange reserves". Given the financial and monetary problems of both the U.S. and Europe as well as simmering political dissension in the European Union, Asians across the board may be fondly eyeing gold as a refuge from their potentially falling currencies.

Yesterday the President of the German central bank was quoted as saying that the Bundesbank would like to sell some of its gold to earn interest. Following a l999 agreement Germany would be heavily restricted and may be precluded from selling any gold at all until late 2004. It is a little more than curious that these types of statements always seem to pour forth in the midst of a good gold market. There can be little doubt, however, based on past experience that financial and monetary conditions will finally overwhelm both the statements and market activity of central banks, at which point central bankers may see gold as their ally rather than their enemy.

P.S. Rumors to the contrary The U.S. Treasury's gross federal debt has risen $228 billion during the last twelve months. The Secretary of the Treasury has asked Congress for a $750 billion increase in the debt ceiling, which he says, should suffice for two years. Gold anyone?

The volume of all the gold ever mined can occupy a cube 63 feet on each side.