Gold Market Update

March 7, 2002

It seems like Central Banks get a little nervous any time the price of gold starts with a three, at least that is what the timing of the statements made in a Bloomberg interview with Bundesbank President Ernst Welteke on February 12th would imply. The Germans have now taken the next place in the sellers line behind the Bank of England and the Swiss, whose gold sales will end tomorrow and late 2004, respectively. There are two fundamental reasons for the Bundesbank's desire to continue the selling. First, sales are needed to maintain order in the gold market. Using data from Gold Fields Mineral Services' latest Gold Survey, gold demand is 412 tonnes greater than supply from mines and scrap. This supply deficit is made up primarily from Central Bank sales and lending. Second, the gold lease market has dried up. Gold Fields Minerals Services shows net producer hedging in 2001 of negative 101 tonnes. The combination of low interest rates and a rising gold price make forward selling (and speculative shorting) unprofitable. New hedges are not being put on to replace the old ones as they expire. The Bundesbank is one of the leading players in the gold lease market. According to new economy thinking among Central Banks, reserve assets must generate current income, while capital gains count for nothing. Gold becomes unattractive to Central Bankers when it fails to earn the 0.5% to 2.0% returns provided by the lease market, so the Germans will trade their gold for T-bills and Euro-bills. But times are changing, as we find that the new economy moves in cycles just like the old economy did. So this must be the new old economy, one in which Central Bankers find that their negative influence over the gold market is waning. When the Bank of England announced its intention to sell gold in May of 1999, bullion dropped $10.80 in two days. This was followed by a further decline of $25 over the next two months to new 20-year lows ($252) in July of 1999. Contrast this with the market reaction to Mr. Welteke's statements a couple of weeks ago. Gold dropped about $7 in the following two days to $291, then trended back to the $300 level, closing Friday at $298.00, $0.25 higher than the close prior to the Central Banker's interview. Given the stature and influence of the Bundesbank, the performance of gold has been quite amazing.

Another more important reason for Central Banker's disdain for gold is that it is the only viable alternative to the global monetary system, as it is currently managed, because 1) gold is universally accepted as a substitute for paper to settle transactions and 2) gold cannot be created with a printing press. Governments use their control over the supply of money and credit to attempt to manipulate economic performance for the better. They would lose much of the power to do this if gold became preferred over fiat currency. In addition, higher gold prices in terms of reserve currencies (dollars, euros, yen) are indicative of either heightened inflationary expectations, problems with the financial system, or a lack of confidence in government. A low gold price avoids such perceptions. The U.S. government has stated on many occasions that it supports a strong dollar policy. Given the long-established inverse correlation between the trade-weighted dollar and gold, a strong dollar policy must imply a weak gold policy. The government has obviously done what it can to encourage a strong dollar, why would it not do the same to promote a weak gold price? Gold conspiracy theorists would explain the low gold prices of the past five years in terms that suggest more sinister or elaborate motives beyond normal government operations. However, when the global markets decide definitively that the dollar is too strong, inflation is headed higher, or that the financial system is inept, then gold can be expected to move higher. No amount of intervention by the Exchange Stabilization Fund, the Bundesbank, or the Fed can move the market in a direction it does not want to go. If the conspiracy theorists happen to be right in their assertion that gold has been held at artificially low levels, then any serious moves in the opposite direction would probably be all the more explosive. Conspiracies or not, one need look no further than the fundamental economic data to construct a compelling outlook for gold - the rapidly expanding money supply, record levels of business, household, and off-balance sheet debt, and interest rates (both real and nominal) that are at long-term lows.

The most significant feature of the new old economy for readers of this update is that gold is finally starting to move back into the investment mainstream. Press reports have begun to carry a positive slant toward gold. Technical analysts on Wall Street have been bullish on the charts for gold and gold shares. A February 14th report by a Morgan Stanley currency analyst is entitled "From Greenback Rush to Gold Rush". One of the concluding comments: "The rush to gold in Japan signifies Japanese investors' concerns about all currencies, not just the JPY. Gold is the most liquid non currency-specific asset, and is the ultimate geopolitical and financial safe haven asset." Until now, such quotes could only be heard from the mouths of the truest gold bugs. Gold is hard money, it has intrinsic value. Gold is sound money, its supply is limited. These are the two most important attributes of money, yet the current monetary system lacks both.

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