A reader writes in asking about the price of gold and why it keeps falling despite surging US government debt. The thinking here is that gold prices will hedge against a collapse in the US Dollar when the government defaults or “prints money” to the point where it causes hyperinflation or high inflation. This was a very popular bet in 2008/9 and you can be certain that it was an important driver in the price of gold during the big run-up.
In my new book, I refer to gold’s price as having a “faith put” underneath it. Gold isn’t just a commodity, but it’s also viewed as a form of safe money. You could argue that gold is the only universal form of money and has been for quite some time (though I think that is waning to some degree). Because of this its users embed a premium in its price when it is seen as protecting against fiat money and its potential inflationary problems.
But a weird thing has happened in recent years. Despite continuing QE and huge government deficits the price of gold has fallen 35% since its peak in 2011 and is down over 10% from its highs this year. Is there a logical explanation for this? I can’t be certain and I could be totally wrong, but if I had to guess I would argue that some of this “faith put” is coming out of the price over time because the inflation bet has been obviously wrong.
The story goes like this:
- In 2008 & 2009 investors see the Fed printing money and the government debt exploding. They naturally assume that this will lead to inflation because the econ textbooks all teach us that the government “prints money”.
- Instead of buying US Dollar denominated assets you logically buy real assets to protect yourself from the coming high inflation.
- As the years wear on you become convinced that the inflation is still going to come eventually even if it hasn’t come yet.
- But as we near years 3, 4 & 5 the inflation story starts to look a little shaky. What if that high inflation isn’t going to come?
- Then, as year 5 comes and goes the high inflation still hasn’t hit and you begin to totally question the foundational reasons for having ever bought into this theory in the first place.
- Demand continues to slow as the theory looks increasingly shaky….You get the point.
Said differently, gold investors embedded a huge premium in the price of gold betting on a disastrous inflation in 2008 & 2009. And as it’s become more and more obvious that that high inflation isn’t coming the premium has been sucked right back out. That’s my theory anyhow. Who knows if it’s right, but it would seem to make a good deal of sense to me….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
Mike Johnson
Hi Cullen:
Though Gold has some very interesting uses in nano quantities ( quantum superposition of molecule indicated by attached Gold) its real application is in human ornamentation and as souvenirs – jewelry and coins. Since what the market can bear for these uses in these underlying uses before substitutions are made that might set the steady floor for Gold. I see that production may be curtailed in the future in terms of refined ounces due to real flow through costs so less Gold will be brought to market. The 2015 end price might be getting pretty close to *real*. Always enjoy your work, bought the book. 😉
tealeaves
I see the pre-crisis rally (2000 to 2007) theme was about gold as an inflation hedge (or more accurately to protect from falling and negative real yields) and a response to the weak US dollar policy. The post crisis theme was to invest in gold to protect from ongoing central bank reflation (supposed high inflation) tactics. That seemed to work along with most any other asset during QE1 and QE2 but maybe gold rose too fast.
Gold peaked around the Euro-sovereign debt default mania in the fall of 2011. To me the 2011 summer/fall appears to be an important turning point as it was the last significant correction for the US equities, the top of gold, a stronger USD, the bottom for 2 year and short term yields (and the bottom of negative yields) which together suggest the general start in belief in a US economic recovery.
Since late 2011, QE3 (and foreign central bank policy choices) seem to be interpreted as a general vote of confidence in the dollar and the US economy (and a vote against the shiny yellow rock). I don’t think gold will do much of anything unless confidence in the US economy (and hence dollar) falters.
chris kubick
Before I say anything: I’m not a gold bug and I don’t own gold, though I am let’s say gold-curious, right here. Anyway, I find it amusing that everyone seems to be focused on how poorly Gold is doing on the year when in fact it’s outperforming the Russell. It’s had a hard run the last month — but gold does that, it’s a volatile and emotional trade. Also Mclellan made an interesting point recently about how gold is doing priced in euros vs. priced in dollars. That’s the real story here: dollar strength. Why are stocks loving an epically strong dollar? THAT I find very interesting.
mike
Back in yesteryear a US politico, commenting on the financial cost of the Vietnam war,
said the cost didn’t matter because the US had lots of green ink. This is what happens in real life when your fiat currency is accepted globally; as you print more so do the other issuers of major currencies. Magic right? The only problem is gold priced in fiat currencies so the price of gold needs to be ‘managed’
gbgasser
I think the further we get into this crisis (its still a crisis for far too many) and the more people try to figure out the system there comes a point when people realize the vacuous nature of gold. Gold cannot deliver what it promises………. because NOTHING can.
People are slowly opening their eyes to economic/monetary reality. Only those with power have a hedge on future losses. The average guy, no matter what he buys, cannot guarantee security. And in reality, the powerful’ “insurance” can be fleeting too. It can all come to an end quickly if we don’t work together to make it so.
Gold is very contrary to what most humans think they want. If you think you want to be truly independent and under no one else’s control then a gold based monetary system is stupid, just as pegging your currency to someone else’s is stupid. But I think the Scotland vote (with about 95% turnout btw) is evidence that we also value unity.
Gold as a currency does not allow us to have the independence we think we want and the unity we need in order to live out our dreams. Gold becomes a goal in itself which most everyone in every religion/social system recognizes as “evil”
Gold is mostly something that some other guy is selling for your hard earned dollars. He’s trying to profit off you. Which is fine but understand what is going on. Its a product.
jswede
may I put “epically strong dollar” into perspective?
Dollar Index Spot (DXY) is at $84.6. It reached a similar level in both 2012 and 2013.
5yr average for DXY is $79.8
10yr average for DXY is $81.3
20yr average for DXY is $90.4
Geoff
Gold could be weak due to the rise in short-term yields. The 2yr Treasury yield has almost doubled since March. Coincidentally, Gold peaked in March.
QCL
Central banks stopped buying
chris kubick
Excellent point, I should have just said, it’s been a nice rally for the dollar over these last few months. Perhaps a bit overbought.
jaymaster
I’ve seen the same thing happen with farm land around here. If you dig back in the comment archives, you will find a point where I was considering buying a farm as a hedge against the “coming inflation”. That was before I was educated by Cullen 🙂
I watched as the asking price for an 88 acre plot of farmland fell from $1.25 million, to $1million, to $895k (when I really got interested), to $750k, to $500k. About a year ago, a local developer bought it for $350k. And he’s got it split out into lots already.
There are real consequences to being wrong about this stuff.
chris kubick
Jay, where was this? That is really interesting, though it makes a lot of sense.
jaymaster
Southern PA. There are dozens of small farms in the area that supply the DC, Baltimore, and Philly markets. I thought sure somebody else would buy it and farm it, but it looks like it will turn into houses.
I also looked at a 20 acre farm a few miles away. It had a nice old house on it too. It sold pretty fast though. The house is still vacant, but somebody has at least been growing corn there the past few years. Of course the way corn prices have gone (down), they might not make out well with that this year.
Jonah The Newfie
Real rates! It moves with real rates. Do a CIX on your Bloomberg using TIPS as your real rate proxy if you want. It is lockstep!
https://img32.imageshack.us/img32/3782/y59t.jpg
jswede
don’t know where to start here…. how about: do think this implies causation?
Vincent Cate
The other way to look at it is that people believe that the QE / money printing is coming to an end. So demand for gold as a hedge against money printing is going down. However, a true gold bug does not believe they will really stop printing money and keeps on buying.
Billy
It was Larry Summers’ thesis, how’s that for support?
disqus_zBM4OWvuk0
1. Since mid-July: Gold (in USD) -7%, Dollar Index +6%. Correlation went to strongly negative -0.93.
2. Nominal yields up a bit. However was countered by very benign CPI (core inflation fell to around 1% over past 3 months annualized). So real yields went up even more. Higher real yields not good for gold price.
3. China appears to have reduced buying physical gold a lot. Swiss gold exports to greater China amounted to 97 and 135 tonnes in January and February, but dwindled to a mere 7 and 4 tonnes in June and July.
4. As Jim Rickards explained we would have deflation if it wasn’t for the massive money printing (I’ll call it printing, even if it isn’t in the strict sense of definition) by central banks. So you have two forces working against each other. So far the outcome has been benign. But, as in arm wrestling, one force may suddenly overwhelm the other, with surprising outcomes.
Mark Caplan
Since 2000, the S&P500 index has increased 33%. Gold has increased 300%.
TimeToPanic
Oh dear.
Gold investors do not reside much in the developed Western world, where GLD and futures are all the rage.
No, real gold investors are the surplus nations, such as Russia and China. They continue to accumulate real physical gold as fast as they can.
They’re also moving to capture the pricing mechanism for the real stuff, eventually the western paper gold bets will prove to be worthless.
Question for you all to ponder….no inflation says Mr Roche, with his eyes fixed solely on the official rate of prices published ( and frequently amended by) the USG.
Yet what was the dot com bubble in 2000? And the housing bubble in 2007? And now the bubble in stocks and corporate bonds?
That’s right, all are iterations of monetary inflation.
The current bubble will burst horribly, and eventually you will see commodities as the focus of monetary inflation, as QE returns with a vengeance.
That is the end game, notably once the world grasps the Euro is so much safer, stronger and more stable than the USD.
Game over, but it will all take at least 15 years to play out.
Zekester7659
The Euro? Really?
And at least 15 years to play out? So no way it will be 14 years?