In memory of Dr. Andreas Höfert

Gold: from deadweight to trump card

| Tags: Andreas Höfert

To say it up front right at the beginning: I don’t like gold. In normal times, it is deadweight in a portfolio: sitting there doing nothing, shining away and paying no interest. Moreover, it runs against the core conception of what financial markets and intermediaries are supposed to do: match savers with investors. It sucks capital out of the economy that could have been better employed elsewhere… in normal times. But those normal times are long gone.

Five years ago, when the financial crisis had begun but wasn’t yet in full swing, gold hit a 27-year high on 1 October 2007 at 747.20 US dollars per ounce. At the time, a rally like this – which started in 2000 and to that point had provided an annual return of 13% – was reason enough to write a small research note. Back then, three possible reasons for the rally came to my mind: a bubble in the making, fundamentals and inflation fears.

The bubble in the making was disregarded back then, as it is now. Between the low of August 1976 and the high of January 1980, the gold price increased by over 92% per year – a very dramatic increase – within just three years and four months. The current gold rally started in April 2001 and reached its latest peak in September 2011, a much longer period of ten-and-a-half years with a much less dramatic increase of 20.5% per year.

Moreover, from a technical perspective, the price of gold is currently 16% over its 30-month moving average. It was 48% above its 30-month moving average in September 2011, and a whopping 230% above its 30-month moving average at the peak of January 1980. From this we can conclude that if a bubble is indeed in the making, it is rather slow to inflate compared with the late 1970s.

Fundamentals of supply and demand also seem more or less balanced right now. Hence they don’t offer much of an explanation for a further rally in gold, either.

So this leaves us with the third potential explanation for the whole gold rally: inflation fears. But are these fears rational? To answer this question, let’s quickly review some events of the last two months:

Highly indebted France managed to sell some short-term government bonds at negative interest rates. This despite the fact that its government acknowledges that its own growth forecasts are currently too high, and hence that it might not meet the deficit targets it has agreed to.

European Central Bank President Mario Draghi announces OMT (outright market transactions). These are unlimited bond purchases from European periphery countries, which the ECB intends to sterilize. Monetary economics 101 tells you that you cannot have in the same sentence “unlimited” – potentially using more than the current balance sheet of a central bank – and “sterilized” – limiting the purchases to the current balance sheet.

The Federal Reserve still refuses to acknowledge the fact that US trend growth has been broken during the financial crisis. Another round of quantitative easing is likely since unemployment is not retreating as fast as it did in the 1980s or 1990s, pushing the monetary base from three times its 2008 level to four times.

Other central banks like the Bank of England and the Swiss National Bank have joined the club of “nontraditional monetary policy measures” – the current politically correct expression for running the printing presses hot.

Of course, this doesn’t necessarily mean that inflation is right around the corner. But at least having some gold in the portfolio would mitigate its impact should the inflation scenario ultimately play out.  

But what about deflation? What if we have it all wrong and the ultimate outcome for the global economy resembles a Japan-like scenario or even worse? Even then, gold should hold the line. During the Great Depression of the 1930s, the gold price was one of the few that didn’t deflate. This thanks to Roosevelt’s experiment of debasing the US dollar by 30% – an experiment, by the way, which is completely dwarfed by the one that Western central banks are currently conducting.