Paul van Eeden
The Federal Open Market Committee recently announced that the US central bank will “… continue to employ a wide range of tools to promote economic recovery and to preserve price stability.”
This means that the Fed will continue to buy agency and Treasury debt in the market to suppress interest rates and that it will do so with newly created money to keep prices from falling in aggregate. The Fed said that it would purchase a total of $1.25 trillion worth of agency mortgage-backed assets and $200 billion worth of agency debt by the end of the first quarter of 2010. It would also have bought $300 billion worth of Treasury debt by the end of October 2009. Since December 2007 the Fed’s balance sheet has already expanded by $1.2 trillion.
That $1.2 trillion, for the most part, represents new money that the Fed created. When the Fed creates new money it inflates the money supply, which, in turn, devalues the dollar. That is how the Fed hopes to prevent prices from falling and keep prices rising: by devaluing the dollar.
All this inflation the Fed is creating by monetizing agency and Treasury debt has fired a healthy fear of inflation in the hearts and minds of many. Fear of inflation has created demand for investments that act as inflation hedges and that is at least one of the drivers behind the current rally in the gold price.
The other usual driver behind increases in the gold price is weakness in the US dollar exchange rate. As the US dollar exchange rate falls the gold price in US dollars rises; not because of increased demand for gold, but merely to bring the US dollar gold price back in line with the gold price in other currencies.
Since there is palpable fear of further future inflation and widespread concern that the US dollar will continue to weaken against other currencies as it loses its status as the global reserve currency, it is no surprise that some of those concerns and fears are being manifested in a higher gold price. Gold is currently trading for more than its fair value yet since markets are forward looking a case can be made that the premium in the gold price is merely a reflection of what is to come.
The question before us is therefore whether the rally in the gold price is founded in reality, or in fear induced fantasy.
As a reminder, the fair value of gold in terms of US dollars increases in proportion to the dollar’s inflation rate. Thus the $1.2 trillion expansion of the Fed’s balance sheet should cause the value of gold to increase versus the dollar. For a more detailed look at how the value of gold can be calculated please refer to the articles on my website: link.
For us to know whether the rally in the gold price is rational, or not, we need to do some accounting.
In December 2007 the US money supply as measured by the Actual Money Supply (link) was approximately $7.5 trillion. The current money supply is approximately $8.4 trillion, an increase of roughly $900 billion over the twenty months since January 2008.
We also know that the Fed’s balance sheet has expanded by $1.2 trillion over the same period of time. We cannot merely assume, however, that the entire $1.2 trillion expansion of the Fed’s balance sheet represents an increase in the money supply. Items that added to reserves (increased the money supply) on the Fed’s balance sheet increased by approximately $1.2 trillion, and items that reduced reserves (removed money from the money supply) increased by approximately $300 billion. That means that the expansion of the Fed’s balance sheet since January 2008 added approximately $900 billion to the US money supply.
The money supply also increases as new bank loans are created and decreases as bank loans are paid back, when banks issue equity, or when banks borrow money by selling bonds. Bank profits also decrease the money supply.
So we know that the US money supply since January 2008 increased by about $900 billion and that happens to be about the same as the total amount of money that the Fed created during the same period by monetizing US agency and Treasury debt, and from the bailouts of AIG and Bear Sterns.
Since the increase in the US money supply equals the increase in the money created by the Fed we also know that new bank loan creation was almost exactly offset by the recapitalization of the banks through equity issuances, bond issuances and from operating profits. This implies that if the Fed had not added to the money supply the US money supply would have not grown at all since January 2008 – a highly unusual condition for a fractional banking system based on fiat money.
However, it is anticipated that the banks have more assets that they’ll have to write down, which means they will have to raise more capital. The Fed continues to monetize agency and Treasury debt to combat the deflationary impact on the money supply when banks raise capital.
Since the credit crisis came to light, the Fed has been creating new money and increasing the US money supply, while the banks have been sucking money out of the money supply to recapitalize themselves.
What we need to take home from this is that while the Fed has been increasing the money supply by monetizing debt, the extent to which it has inflated the money supply is $900 billion. Not $12 trillion, or $24 trillion, or any other absurd number that gets bantered about the Internet.
And while the increase in the US money supply as a result of the Fed’s priming is material, and has maintained US monetary inflation at historically high levels, it is nowhere near hyper-inflationary rates, nor is there any reason to believe that hyperinflation is remotely likely in the US.
We can calculate the percentage change in the US money supply on a year-over-year basis for each month, and then calculate a rolling 12-month average of the monthly, year-over-year changes (link). The average increase in the US money supply over the past twelve months, on that basis, has been 8.44%. That is a very high rate of monetary inflation for the United States. For example, the average inflation rate during the 1970s was 8.33% based on the increase in the Actual Money Supply.
To correctly analyze gold’s value vis-Ã -vis the dollar we also have to consider the inflation rate of the gold supply. The value of gold declines in proportion to the net amount of gold that is added to the above ground supply of gold just like dollar inflation devalues the dollar. While I don’t yet have all the gold production and consumption data for 2009 to complete the calculation, I estimate that the gold inflation rate could be around 1.5% for the year.
For a quick and dirty answer we can subtract the expected gold inflation rate from the dollar’s inflation rate (~8.5% less ~1.5%) to arrive at a rough guide to what gold’s average value for 2009 could be in terms of US dollars. The average value of gold was $762 an ounce in 2008. If we now add ~7% to that we arrive at an estimate of $815 an ounce as the average value of gold in terms of US dollars for 2009.
Take note that that is an average value for the year, and not a year-end or current date value. Nor is it a price prediction. This method of valuing gold is an attempt to quantify the value of gold, not predict its price.
The reason for doing it, though, is that we can see what effect the monetary inflation rate of the US dollar has on the value of gold in terms of US dollars. As you can see, the Fed’s activities have indeed had a positive impact on the value of gold, but not nearly as much as the market is factoring into the gold price.
The average gold price for September was $997 an ounce and gold is currently trading well over $1,000 an ounce. The current gold price is more than 25% higher than its estimated average value for 2009, and even though we would expect the current value to exceed the average value for 2009, it would not be nearly by that much.
The market appears to be too fearful of inflation and has factored too much potential future inflation into the gold price. The Fed clearly announced that it would end the monetization of Treasury debt by the end of October this year and the monetization of agency debt in the fist quarter of next year. That means that in six months’ time the Fed will stop creating inflation. I realize that the FOMC could decide to extend the monetization of debt, but at this time we have no reason to believe that it will. Therefore it seems to me that the current bout of Fed manufactured inflation is coming to an end.
The US government, however, will continue to run a massive deficit that has to be financed with the issuance of Treasury debt. Assuming the Fed stops supporting the bond market and the Treasury keeps issuing record quantities of new debt, we can expect to see US interest rates start moving up.
The current level of interest rates in the US is historically, and unnaturally low. Interest rates will rise. It’s a question of “when”, not “if”. Given that the Fed has announced it will stop supporting interest rates in six months, and that the market is forward looking, it could be sooner rather than later.
Rising interest rates could be positive for the dollar in spite of the massive issuances of US Treasury debt, and that could put downward pressure on the gold price since the gold price moves inversely to the dollar’s exchange rate.
So in spite of the fact that the Fed has been inflating the US money supply by monetizing debt, and in spite of the fact that dollar-bearishness is in abundant supply, and that the US dollar is very likely losing its status as the sole reserve currency, there is a good chance that US interest rates will have to rise and that could cause a rally in the US dollar and a decline in the gold price.
Gold bugs have been conditioned to believe that the gold price has to rise in times of financial or political turmoil. But that is not necessarily the case. Lately, when greed dominates the market large institutions buy emerging market and Asian assets, and sell US dollars. That puts downward pressure on the dollar exchange rate and causes the gold price to rally. In other words, the gold price rallies when things are going well and greed is the dominant emotion.
When fear grips the market institutions sell emerging market and Asian assets and buy US dollars, sending the dollar exchange rate higher and putting downward pressure on the gold price. So when things go bad, the gold price falls.
During 2008, in spite of the fact that the United States was the epicenter of the financial crisis, the US dollar rallied, money poured in US bonds, and the gold price fell. Just a few weeks ago, when the US housing data disappointed the market, the dollar rallied and the gold price fell.
The belief that the gold price will respond positively to bad news and fear could well be misplaced, and is certainly not supported by recent market movements. It also ignores the fundamental and underlying factors that determine the value of gold and moves its price.
Aside from money, inflation and exchange rates, we hear a lot about China and its impact on markets. Chinese residents are now allowed to buy gold. China buys vast quantities of all sorts of raw materials such as copper, iron and oil and hope has been pinned on China’s revival since the economic crisis began. The Chinese economy barreled ahead as if nothing happened while North America, Europe and Japan’s economies collapsed.
Exports represented 35% of China’s GDP last year, according the World Bank website. China’s exports fell approximately 30% since last year, which means we would have expected China’s GDP to decline by more than 10% this year. Instead, the Chinese economy grew by 8%! How is that possible?
The Chinese government announced a massive stimulus program, much larger than the US stimulus package as a percentage of GDP. Yet it is almost certain that only a portion of the stimulus plan has been executed. A more likely source for China’s growth is the expansion of its bank credit this year. Bank credit in China has increased by 28% of GDP since January. To put that in perspective, that is equivalent to a $4 trillion increase in the US money supply, more than ten times the amount by which the US money supply actually did increase since January this year. Anyone concerned about inflation should be concerned about the inflation of the Chinese renminbi.
But I got side tracked; we were talking about the Chinese economy’s miracle growth. The theory goes that the credit expansion in China is fueling a consumer binge to such an extent that China’s internal consumption has replaced the lost export markets and then some. Before we just take this on blind faith, we should note that China’s economic numbers are not calculated in the same way as equivalent figures in North America. Specifically, in North America GDP is measured by expenditures while China’s GDP is based on production; and that is a very material difference.
For instance, the manufacturing of products is a component of Chinese GDP and not the sale of those products. Consider that if China wanted to increase its GDP all it had to do was produce more goods without regard for whether there was a market for those goods. Of course, manufacturers cannot continue to produce more and more without selling their products – they will rapidly run of money. But they could if the banks are willing to lend them money to build inventories of manufactured goods. I have a sneaky suspicion that the explosion of Chinese bank credit was used to finance a massive increase in production so that GDP growth would meet the Party’s expectations.
This would explain quite a lot, and it has severe repercussions. It would explain why China continued to buy large quantities of raw materials that could not be reconciled with the collapse in the market for its goods (exports). An economy cannot sustain itself if debt is used to manufacture products for which there is no market. Either the banks, or the manufacturers, or the retailers have to eat the losses. Regardless of where those losses come home to roost such an economy as a whole is rotten to the core.
The inconsistency in the Chinese data and the anecdotal evidence that China is building vast inventories can only be reconciled if one assumes that there was a surge in the production of goods that now decay in stock yards and warehouses. That means that China’s economy has the potential to implode with a reverberating bang unlike any other that has ever emanated from the East.
The Chinese Communist Party apparently learned from America that debt financed consumption was not a sustainable economic model. Their solution, it seems, is even more absurd: debt financed production in the absence of demand.
While such an economic model is flawed, China has vast resources, such as approximately $2 trillion in reserve assets, with which it can finance its folly. That implies that the Chinese conundrum could last much longer than we may expect. Even so, just like the debt financed US consumer spending spree had to come to an end, so too must China’s debt financed demandless production spree.
Earlier we reached the conclusion that US interest rates could potentially start increasing and cause the US dollar exchange rate to strengthen, which, in turn, would cause the gold price to fall. We can now add that the massive inflation of China’s money supply can cause the renminbi to collapse and send another currency crises rippling through financial markets. A collapse of the Chinese renminbi could also result in a stronger dollar and lower gold price.
But consider what could happen when the Chinese miracle economy is unveiled to be no better than the US miracle economy had been.
Last year when the US was the epicenter of the financial crises the US dollar rallied and the gold price fell. What would happen if China were the epicenter of an economic collapse? What happens when the gold and commodity bulls realize China cannot continue to consume at an even greater pace than it had been when the world was buying its goods, but, instead, now has to work down the excess inventory it built up? It would be a good bet that the US dollar would rally and the gold price would fall.
Given that the gold price is trading at a 25% premium to its fair value and that we can imagine several scenarios whereby the US dollar could rally and the gold price could fall, it seems to me that betting on a higher gold price right now is merely a bet on the Greater Fool Theory. That is not to say that the gold price could not continue to rally – markets can remain irrational far longer than rational people ever imagine they would. Personally, though, I have no interest in buying an over-priced asset in the hope that it will become even more over priced – not even gold.
Paul van Eeden
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