August 16, 2010
I have been speaking and writing about gold’s
appeal in a deflationary environment – this is a
concept that opposes the conventional opinion that
the gold price will not rise without inflation.
Those who cling to that singular gold-inflation
relationship have not examined the history of gold
as money. Whenever there is substantial inflation or
deflation, governments tend to either be too slow to
react or they overreact with policies, and this is
typically good for gold.
Interest earned on 90-day Treasury bills below
the inflation rate is a signal for governments to
try to stop deflation and reflate the economy. When
this happens, gold becomes attractive. We are in
such an environment now.
During these periods, governments usually need to
increase their deficits by escalating their
borrowings to support the economy. This also
supports gold as safe money in addition to its
beauty as jewelry.
The twin engines of negative real interest rates
and government deficits tend to make gold a very
attractive investment. Recent research supports our
historical findings on what drives gold.
This chart from Deutsche Bank shows that for the
past four decades gold (and silver) have performed
well in a country’s currency when that country has
low or negative real interest rates.
The Federal Reserve’s main interest rate is
near zero and inflation is a little over 1 percent,
so we now find ourselves in a negative real interest
rate situation. The Fed has made it clear that it
has no plans to tighten money by raising that key
rate any time soon because of the sluggish economy
and soft housing market (mortgages are now at a
21-year low), so this condition is likely to endure.
“The decline in core inflation from 2.5 percent
two years ago to under 1 percent today will sustain
market fears of deflation and hence a more rapid
depreciation of the U.S. dollar to arrest any
deflationary pressures,” Deutsche Bank’s
analysts wrote. “We believe that the road map to
resolve deflation is therefore bearish for the U.S.
dollar and another factor which will propel gold
prices to new highs.”
The Fed this week plotted part of that road map
– it said it will pump more money into the system
to try to kick up economic activity. As the 2010
midterm election draws closer, there is also a
growing call for another round of stimulus spending
to try to pull down the 9.5 percent unemployment
rate.
Such a move would widen the federal budget
deficit, which is already estimated at nearly $1.5
trillion for this year and will roughly be the same
in 2011. The U.S. dollar is not only our currency,
it is also the world’s reserve currency. Deficit
spending puts downward pressure on the dollar, and
when the dollar falls, investors tend to turn to
gold.
When you add the interest rate and deficit
scenarios to the gold seasonality trend –
September is historically the best month of the year
for both bullion and gold equities – the
conditions now appear promising for gold.
We discuss What’s Driving Gold in an
interactive presentation – click on the chart to
learn more about these critical drivers.
