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Nov 2007

Gold has been in a bull market since 2000, with the nominal price coming very close to its all time high of $ 854 per troy ounce (which was registered in 1980) earlier this month, before slipping back around $ 800. There have been many reasons bruited about for the gold rally – the broader commodity bull run, supply demand imbalances, fear of inflation, Fed easing (particularly the sharp 50 point cut in August, which triggered the last wave of gold buying, which took it from $ 642 on August 16 to $ 845 on November 7), dollar weakness, and so on. In many quarters, sentiment for gold remains extremely bullish and there are analysts as celebrated as Mark Faber and as implicated as Gold Field Mineral Services (GFMS) who are looking for $ 1,000 an ounce.

So why are gold prices rising so relentlessly? Are we, indeed, entering into a new era of a new gold standard, in a sense, with the dollar debased and gold (and other commodities) driving world markets? Or are we close to the end of the surge in gold, and, correspondingly, the end of the decline of the dollar?

Part of the commodity bull market?

The rise in gold has been seen as part of a wider commodity bull market. In this current boom, nominal commodity prices have risen hugely. Crude oil prices have soared nearly six times over the past 7 years, and are perilously close to $100 per barrel. Likewise, copper has risen by nearly 600% over the period to 8,700. Over the same period, gold prices have risen by just 200%.

If we look at real – i.e., inflation-adjusted – prices, the differences sharpen dramatically. The graph shows the nominal and real prices (using today's prices and adjusting backwards by the US CPI) of gold. Rather surprisingly, the price of gold in inflation-adjusted terms remains way below the (inflation-adjusted) high of nearly $1,850 reached in 1979/80. In contrast, other commodities are very close to their inflation-adjusted peaks of the 1970's and 1980's – the inflation-adjusted peak in oil was $ 105 (compared to the recent nominal peak of $ 97), in copper $ 8,700 (compared to the recent nominal high of $ 8,751). Thus, gold, in real terms, has not even reached half the level of its all-time high.

This then, begs the question, is this really a bull market in gold? Alternatively, is gold really a part of the commodity bull market or is there some other force affecting gold price?
Gold has always been something of a this-and-that, partly commodity, partly monetary aggregate. It's volatility, too, has hovered between 15% and 25%, between that of currencies (8-15%) and commodities (25-60%). This is probably because, unlike other commodities that get “used up” at different rates depending on global growth, gold, once mined, remains in circulation, usually as adornment or as an investment.

GFMS estimates that at the end of 2007, total aboveground stocks were about 160,000 tonnes, of which 67% had been mined since 1950. Against this huge “stock”, annual gold consumption is a mere 3,900 tonnes. Of this demand, about 2,500 tonnes is met by mine production, and the balance is met by sales of scrap and by central banks. With central bank sales limited by agreement to 500 tonnes a year, it would seem clear that some part of the rising price of gold over the past few years has been driven by the supply-demand imbalance. However, given the huge overhang of stock, it stands to reason that gold prices cannot continue to rise on pure supply/demand considerations since there will always be scrap sales available at every price rise.

On the other hand, most other commodities , which have been rising since 2002 on the China demand story, have no natural buffer of stock to limit their upside. This may explain the difference in the scale of the price rise.

Inflation ahead

Turning to its other avatar, gold also behaves like a currency and a store of value. In particular, gold has been, and has been seen as, an inflation hedge for decades – indeed, centuries. Historically, a rise in the price of gold was, in most instances, a forerunner of a rise in inflation.

Of course, no relationship in financial markets is perfect, and gold does not provide an exact inflation hedge. If it did, the real – i.e., inflation-adjusted – price of gold should be a straight line. Nonetheless, it is interesting to see that even the real price of gold is very highly correlated with inflation – at least, US inflation. Thus, through the 1990s, when inflation was falling, the real price of gold was falling, and, in fact, has turned higher only this century, when the US CPI has become a bit more volatile and, indeed, has trended slightly higher.
Given this stronger, second order link with inflation, one would expect that the rise in real gold prices we have seen, particularly over the past couple of years, should definitively be signaling higher inflation. And indeed, latest data do show that US headline consumer price inflation (inclusive of food and energy prices) has risen from 2% to 3.5% over the past two months, and, significantly, Mr. Bernanke has announced that from here on he will be targeting overall (and not core) inflation. Prices in the Eurozone rose at 2.6% last month, which is extremely high by European standards. Only Japan is once again teetering on the brink of deflation.

Again, prices have been rising sharply in China, triggering a steady stream of cash reserve and interest rate hikes by the Chinese authorities. While it is conceivable that China may be able to rein in prices, the fact remains that industrial production there is on fire (hitting 17.8% in October), which suggests that, sooner rather than later, the Chinese government will have to relent and permit a much more substantive revaluation of the yuan in order to rein in the economy. This would force Chinese export prices higher and reduce – and, perhaps, dramatically – the impact of the much-hyped Chinese-prices-causing-deflation story. Already, the sharp appreciation of the rupee over the past six months has resulted in Indian companies becoming more aggressive with prices in the global market. Thus, we could see the Chindia attenuation of global inflation lose a bit of its power. Indeed, no less a global guru than Alan Greenspan shares this view, and believes that inflation is about to show its snarling face again.

Bond markets, however, appear to be signaling something quite different. The US 10-year bond is yielding less than 4.25%, which, in normal circumstances, would suggest benign inflation in the future. However, as always, circumstances are hardly normal. With the fallout from the sub-prime crisis gathering steam – there are respected analysts who believe the impact on lending could be as high as USD 2 trillion – it stands to reason that there would be a flood of money into risk-free assets like US treasuries, which is pushing yields down. On the other hand, it is certainly significant that even though the 10-year yield has fallen from its recent high of 5.31% in June this year, the slope of the yield curve has risen quite sharply and is currently at its highest level since February 2005. An upwardly sloping yield curve suggests strong growth in the future and/or higher expected inflation. With growth – at least in the US – likely to be severely constrained by the credit crunch, it is more likely that the yield curve, like the real gold price, is signaling inflation ahead.

Which puts the Fed in a bind

This puts the Fed in a bind. The market seems to have no doubt that the US economy is slowing – the probability of a December rate cut is seen at nearly 90%. Indeed, there are armies of hysterical analysts who want more – much more – and the futures markets are discounting two more rate cuts, all the way out to March 2008, which would take the Fed funds rate to below 4%. In this environment, if the Fed doesn't cut rates, the equity markets, which are more edgy than usual of late, could go into a serious funk.

On the other hand, if it does, inflation, as we have argued earlier, is a real threat, getting stronger all the time.

There is little doubt that the Fed will cut rates by 25 basis points on December 11. However, the key question is how it will couch its perception of the balance of risks between growth and inflation. If it is hawkish on inflation, equities may tank; if it sounds more concerned about growth, the market, more ready than ever to pounce, will mark the dollar – again, more than tender of late – down sharply.

Net net, it looks like its time to pay the piper. Try as the Fed might, it will not be able to avert a sharp fall in the dollar and a sharp fall in equities, or both.

So, is this the end of the dollar?

The volume and intensity of talk about the end of the dollar has been increasing in recent months, as the dollar index has been regularly hitting all-time lows, and has also broken some very strong psychological levels, particularly 1 to the Canadian dollar. Nonetheless, paraphrasing Mark Twain (as has been done a lot recently), we believe that talk about the demise of the dollar is highly exaggerated.

Certainly, the Chinese, the Russian and the Middle East central banks and, even our own Reserve Bank, have made loud noises about diversifying their reserves out of dollars. Of course, since the people running these institutions are unlikely to be particularly naïve, chances are that a large part of the diversification has been completed before they opened their mouths about it. And while it seems likely that fresh reserves will not be allocated as heavily into dollars as they were earlier, the flip side is that, over the past few years, the US current account deficit has been shrinking courtesy the falling dollar. As a result, the US needs reducing amounts of flows (at least, as a percentage of GDP) to support its deficit, so this increased diversification – if, indeed, it does happen – may not prove to be too much of a problem for the US, or the dollar.

The other big noise about the end of the dollar has to do with oil (and other commodity) producers feeling the pinch of a weak dollar and looking to shift invoicing into Euros and/or other currencies. These noises have been around a long time – in fact, there are many who believe the Iraq invasion was the result of Saddam's efforts to dehegemonize the dollar in this fashion. Iran and Venezuela, in particular, have been ranting about repricing oil in Euros. However, the crude Big Daddy of crude – i.e., Saudi Arabia – ain't having none. Obviously, this is US, as much as Saudi policy, and it remains to be seen how the next President, particularly if it is a Democrat, will be able to square the circle of maintaining the Saudi relationship in the face of the Saudis continuing indifference to human rights. On the other hand, however, if, as we believe, the dollar turns around [see below], the pressure on commodity producers may ease soon.

In any event, much as the possibility of the end of dollar hegemony appeals to many, mostly from a who-does-the-US-think-it-is perspective, the reality is that a world without an anchor currency is unfeasible. It would generate much too much uncertainty for business, reducing global trade and killing, or certainly seriously wounding, the golden goose of world growth. There are some analysts who see the extravagant dollar weakness as a sign of impending structural change and have mooted such strange ideas as a return to a new gold standard; in our view, this is a non-starter, since it would mean going back to fixed exchange rates, giving up independence of monetary policy and exposing domestic economies to exogenous shocks.

Of course, this talk will persist, and, together with the Fed's December rate cut, will keep the dollar off balance. Indeed, the dollar seems ripe for one more, major blow out – say, to 1.55 (or more) to the Euro either right before the January or the March Fed meeting. But by early – or, at latest, mid – next year, by which time the Fed will be definitively done cutting rates, the talk will begin to sound more and more hollow, and the dollar will rebound sharply.

We need to recognize that markets do not move in one direction forever, and, when they turn, they do so inexplicably, but with 20/20 hindsight. I remember back at the end of 2000, when the dollar was as strong as strong can be. Gold was in the gutter (around $ 250), nobody even talked about it, except to shake their heads and laugh. Japan was in the throes of its deflationary spiral and it didn't look like it knew which way was up. Europe was just coming to grips with the Euro and there were many skeptics (self included) who wondered whether the Euro would hold. There was just no place, other than dollars, to put your money. So the dollar strengthened, and strengthened, and strengthened.

Around October or November of 2000, Dr. Risk, who is our most learned market guru, pointed out that everywhere we looked we could only find convincing evidence that the dollar would strengthen. He felt in such an environment, we needed to try and find a logical argument on the other side – that the dollar would fall. He set about trying to produce a detailed argument for a dollar decline. But, you know what? He couldn't. He couldn't come up with any convincing arguments, because he himself was unconvinced that the dollar should weaken.

Which, of course, it did. Some time in early 2001, when it began to look like the US would be slowing down more than the market expected, the dollar started to slide. And then there was 9/11 and boom – goodbye dollar.

Well, the dollar's been weakening since then and, in an uncanny (if reversed) scenario, it is hard, if not impossible, to find reasons for the dollar trend to turn.

Everything points to a weaker dollar. The US economy is in a funk and seasoned analysts, like Bill Gross, expect the Fed funds rate to come down to under 4%. There are wild-eyed analysts, like Jim Rogers and Mark Faber, talking about the end of the dollar. And, with the dollar's long, long decline – and 5 or 6 years can seem like a lifetime in financial markets – the hundreds of thousands of players (companies, individuals, speculators) who have been living with dollar's weakness can hardly think of a different market environment. In other words, the bandwagon is almost fully loaded.

Which, as we all know, is a prerequisite for a major turning point.

And, as before, it is well nigh impossible to see why the dollar will turn. But turn it will. And we will all, at that time, understand exactly why it happened.

Clutching at a few straws we see in the wind, we note that the dollar's continuous fall over the past several years has already had several positive effects. First off, US exports are growing like gangbusters, almost as if the US were an emerging economy – over 17% at last report.

Secondly, the immovable Chinese dragon is beginning to feel huge pressure from inflation as a result of being de facto pegged to the depreciating dollar. The government has raised reserve requirements 9 times and interest rates 5 times so far this year. Clearly, as in India (7 CRR and 2 reverse repo hikes), monetary instruments are inadequate to manage monster growth. So, sooner rather than later, there will need to be a much sharper appreciation of the yuan than we have seen recently, which, while cooling the Chinese economy, will push global prices higher, keeping inflation on the boil and US interest rates from coming down. While there may not be the 10% bolus we saw in India earlier this year, I think there's little doubt that the yuan will appreciate more than the rupee during 2008. This strengthening of the yuan would release the pressure on other major currencies, which, with a glorious European sigh of relief, would slip, slide, fall against the dollar.

How low?

Well, only a fool forecasts both a turning point and a level, so we'll leave it at that.

So what about the rupee?

The rupee, of course, remains an enigma. Capital flows into India appear to have a life of their own, unbothered by things like financial mismanagement (adding in the various subsidies shows the true picture of our fiscal deficit) or a dramatic increase in global risk aversion (the VIX index has risen to levels not seen since the end of the tech collapse in 2003). Indeed, there are many views that believe that the global credit crisis is actually increasing the flow of funds to emerging markets. Political foibles, problems in Pakistan, signs of slowing consumer demand – none of these seem to have any impact on India's attractiveness.

This could be because India is still seen as cheap – even at 39 to the dollar, P/Es (in some cases) above 50 and real estate prices matching global peaks. Or, it could be that there is a continuous and growing flood of new investors who don't want to (can't afford to) miss the India bus.

And, indeed, there are some signs that the bus is getting sturdier. The government recently announced a dramatic reduction of ministerial vetting of infrastructure projects, which could speed up money into the ground, which in turn would provide the double bonanza of helping RBI manage liquidity and improving productivity. There also appear to be a large number of projects that had been approved which are coming closer to fruition. Perhaps, the bus isn't going to slow down significantly, and new passengers will just have to continue to scramble to get on.

Again, RBI is showing renewed signs of life, having taken the bit between its teeth on currency futures. While it will doubtless have to battle for control (SEBI is also keen to regulate currency futures) and manage the legal and structural issues, it does look like we will have an operating currency futures market in 2008. This would both provide additional value to residents by broad-basing the market and also serve to keep global investors excited about the India story.

On the other hand, if, as we expect, inflation remains a threat globally, domestic interest rates, which are just starting to ease, could stop falling – indeed, by end 2008, we may even see rates rise. On the one hand, this would underpin the rupee, but it would also increase pressure on corporate profits and the bus, overcrowded as it is, could begin to wobble a bit. Add into this the possible dollar strength overseas and we could have some real uncertainty as to the direction of the rupee towards the second half of next year.

Returning to gold

As long as inflation remains a threat, we would not expect the real price of gold to fall from current levels. Indeed, if the scenario we have outlined above – one more bout of serious dollar weakness, followed by a which has risen from 12% of total demand in 2005 to recovery – prevails, we will likely see gold shoot higher, around 28% today – which would send gold perhaps breaching its all-time high (in nominal terms). plummeting sharply.

This, however, will be its last hurrah. Of course, this drama can only happen if/when inflation starts to ease – perhaps, towards the end of the first half Once the dollar turns, demanding obeisance to the of next year. nearly 100% negative correlation that gold has shown with the dollar over the years, gold will begin to fall. In We forecast an extremely volatile year for gold, with particular, we would point out that the during the last the nominal price rising to near $ 900 in the early run-up, gold showed a stronger than usual correlation part of the year, followed by sharp declines to with the Euro, suggesting a significant part of its rise around $ 650. The rupee will remain well bid, in was, in fact, driven by dollar weakness. At some point, general, but will respond to dollar strength in the this could trigger a serious unwinding of speculative second half of the year – we forecast a range of 38 longs – euphemistically called investment demand, to 40.50 for 2008.