THE
MOST IMPORTANT DRIVER OF GOLD & COMMODITY PRICES
A Picture Worth 1,000 Gold Coins!
by Jas
Jain
February 7,
2005
The attached graph must look familiar to a commodity speculator, in general, and a gold bug, in particular. But, this is not a chart of gold or any commodity; it is a chart of risk-free returns on USD for an American after paying taxes and subtracting the inflation rate. I have used the Fed Funds rate as a proxy for risk-free return (closely mirrored by 3-month T-Bills). To smooth out the noise, for a better long-term perspective, I have taken 3-year average of the Fed Funds rate and the inflation rate, centered 18 months on either side. I have used a 35% tax rate (there are no state taxes on T-Bills); a change in this rate would not have any significant impact on the shape of this graph.
I have color-coded the graph based on whether gold is a better investment (when the real return on cash in negative) or the greenback is a better investment at any given point in time. Please remember that an investment is characterized by the income, or returns, that it generates. The long-term return on gold equals the inflation rate. Hence, I am looking at real returns. One can derive a similar graph in other currencies.
1980 was a watershed year for the US monetary policy – from June to December the real Fed Funds rate went from –10% to +4%. It put in motion the greatest changes in investments in the past 55 years. Gold reacted to it the first, followed by the US treasury market, and, finally, in August of 1982 the stock market. Prior to this change, the gold and commodity markets were primed for double-digit inflation to continue for as long as the eye can see. Then came a dramatic reversal in inflation rate driven by a choking monetary policy that brought the US economy to its knees.
(There are two time points during the economic Longwave, which lasts 50-75 years, during which Cash is truly the king. One is soon after the inflation peaks, and it came in July 1981 the last time, and the other is soon after the inflation bottoms and is negative, i.e., we have outright deflation. The later point has not yet arrived and lies ahead; until then the US Treasury bond yields will keep falling. The amount of stimulus that it took to keep the inflation rate from falling below zero suggests that the next time, lot sooner than you think, the inflation rate starts falling there would be not much left to stop it from entering the negative territory. As I have noted already, the inflation rate for the past 6 months is only 0.63% annualized).
Gold As Insurance
I have been recommending 5-10% of one's net worth in gold. This is an insurance against the failure of the financial system, the probability of which keeps increasing every day that the current unsustainable US politico-economic system stays in place. Even Greenspan has acknowledged that things that are unsustainable are not sustained. (Preparing the middle-class for bankruptcy and transferring all their savings into few hands is NOT sustainable). Nothing I say about gold as an investment, or a speculative play, changes its unique value as insurance against the failure of the financial system. Insurance is a cost and well worth it if the event that you insure against takes place. A thousand 1-ounce gold coins are a sufficient insurance. If you are not there yet keep working!
Gold and Monetary Policy, 1966-1980
As you can see from the graph, the US monetary policy, especially under Nixon from 1971-1973, was very irresponsible and allowed the inflation and inflationary psychology to take root. THE ARAB OIL EMBARGO WAS NOT THE CAUSE OF THE 1970S INFLATION. The inflationary monetary policy continued under Ford and then under Carter, who finally did something about it by appointing the inflation-sleuth Paul Volcker. The Volcker policy to kill inflation at all costs was the death-nail for the gold bubble and the reaction was swift. The cost was the worst recession since 1950.
Gold and Monetary Policy, 1981-2001
For the most part, as the graph illustrates, the monetary policy was unfavorable for gold during 1981-2001, as the after-tax real returns on risk-free US paper was positive and attractive.
Gold and Monetary Policy, 2002-Present
Unlike the short period of stimulative policy during early 1990s, the monetary policy during 2002-4 has been extremely simulative and, hence, positive for gold. Whether it is over or not we will only find out later, but a look at the short-term trend suggests that it might be. A combination of rising Fed Funds Rate, as most expect, and my expectation of falling inflation, as evidenced by the falling long-term rates, are the best guides going forward. If we look at 6-month time-window, as opposed to the 3-year window in the graph, the graph has already turned green from gold, signaling an orange light for gold and green light for the greenback.
How About Commodities?
The above analysis about monetary policy and gold applies to commodities, for the most part, except for the insurance value of gold. However, commodities are more driven by the supply and the end-user demand while gold is partially driven by its value as a currency in addition to consumer demand. I personally think that the recent commodity bubble may be in the process of bursting as the economy slows down.
© 2005 Jas Jain
Editorial Archive
Contact
Information
Jas Jain
Tehachapi, CA USA
Email
The opinions of FSU contributors do not necessarily reflect those of Financial Sense.
