Thursday, May 31, 2012

The Skinny on Shiny Metal

Historically, gold has been the asset to own during a financial crisis or inflation.  Since there is a crisis in Europe, the price of gold should be increasing.  The huge increases in money supply should eventually increase the value of gold.  Instead, it has been crushed!  Why?

As the crisis in Europe has mounted, European investors have been liquidating their gold holdings to pay for other things.  This increases the supply of gold and drives down the market price.

Also, as fear has increased in Europe, investors don't want to own government bonds in Euros.  They want the safety of dollars.  So, they're selling Euro-denominated bonds, which increases the supply of those bonds, which decreases the price, and drives up the borrowing costs of European governments.

What are they buying?  They're buying U.S. Treasuries instead, regardless of whatever the ratings agencies think.  As demand for our dollar-denominated bonds increases, they bid up the price, which drives down our borrowing costs.  The interest cost on our 10-year bonds dropped below 1.6% today, a historical low.

However, you cannot buy U.S. Treasury bonds with Euros.  You need dollars.  So they sell their Euros.  This increases the supply of Euros, which drives down the price.  When they bid to buy dollars, they drive up the price of the dollar, which has appreciated greatly this year.

What does that have to do with gold?  When the dollar appreciates, the value of gold depreciates in terms of dollars.  When the Euro depreciates, as it has, the value of gold appreciates in terms of Euro.  The Europeans think gold has been a great investment this year, because it takes a lot more Euros to buy gold today than it did a few months ago.

What is going to happen?  "Reversion to the mean" is a term explaining that all things will eventually return to normal.  While I have lots of disagreement with that argument, I'm confident the world will eventually return to normal.  Europe will not fall into the ocean.  They will eventually sell dollars to buy Euros again, which will drive up gold to us.  More importantly, the money supply has never increased so rapidly without producing inflation.  I expect that relationship to return to normal as well.  When either or both of those things happen, gold will appreciate or go up in value.

When will that happen?  Nobody is smart enough to know that, but I do have respect for the Commodity King, Jim Rogers, who predicted gold will bottom out around $1,450 per ounce.  If he's right, we can expect another drop of about $110 per ounce.