Gold Market Update

August 8, 2001

The opening quote in the August 3rd Grant's is worth repea7ting: Senator Phil Gramm (R., Texas): "If this is the bust, the boom was sure as hell worth it. You agree with that, right?" Alan Greenspan: "Certainly." This Grant's issue also has some interesting statistics that further illuminate comments made in the last Gold Market Update on the housing sector. Measures such as year-on-year changes in the U.S. housing price index (highest since 1980), homeowner's equity percentage (lowest since WW II), and the ratio of existing home sales to housing starts (roughly 60% higher than the last peak in 1978) indicate that there are bubble-like excesses in the housing sector that have been created through easy credit and a speculative trading mentality. We would add a few other bubbles, such as the U.S. dollar, consumer spending, and the U.S. budget surplus, to get to the crux of Senator Gramm's query.

Producer price inflation may have topped out, as shown by a familiar pattern in the Producer Price Index that appears to have broken trend. Since the second quarter of 1999 the monthly PPI has increased in step fashion every three to four months, however, the PPI has now stalled near the 142 level for the past six months ended June. Also, commodity price deflation is underway as shown by the 12.1% decline in the Commodity Research Bureau Futures Price Index this year. While crude oil prices remain high at over $27 per barrel, natural gas prices have collapsed and the energy crisis has evaporated as the slow economy has dampened demand more than expected. Other commodities, such as industrial metals, wheat, and cotton, have experienced significant price declines. Whereas the Consumer Price Index has risen steadily since 1998, the action in the PPI and commodities indicate that the CPI will now begin to flatten. One caveat to this is the oil price, which could rise with further escalation to the conflict in Israel. With inflation becoming less of a concern, there is an increased chance that the easy monetary policy of the past six months will continue unabated, however, the fact that commodity prices are deflating under the current aggressive monetary easing suggests that Fed policy lacks efficacy. Pulling Asia up from the depths of depression in 1998 and fighting the phantom Y2K meltdown in 1999 cannot compare to the synchronized global contraction now underway. A worse case outcome would be for the deflationary forces currently impacting commodities to spread into downstream products. A universal loss of pricing power would put already weak profits at risk, and ultimately impact the banking sector as companies have difficulty servicing debt. While it is much too early to forecast such a scenario, the PPI statistics indicate that there has been a trend change that now make it a possibility. With this, the roll of gold would also change from an inflation hedge to a hedge against adverse financial conditions brought on by deflationary forces. Gold has a strong inverse relationship to bank stocks, which have performed relatively well as interest rates have declined. Bank share prices or banking indices, such as the BKX (Philadelphia Stock Exchange/BKW Bank Index), should be watched as an economic barometer and to help determine the staying power of any gold rallies.

Bullion has been stuck in the $265 to $270 range for over a month now. Physical demand typically falls off in the summer months and a lack of news during the vacation season keeps many traders on the sidelines. As such, Comex open interest is now at the lowest level of the year and the net spec position has turned slightly short for the first time in several months. August is already looking like a carbon copy of July. Think of the current lackadaisical nature of the gold market as a period of base building. We would be happy to see gold hold these levels going into the holiday seasons. In addition, the infamous month of October looms large as the economic downturn gains momentum.

A sheet of gold can be made thin enough to be transparent

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