Gold and Newton’s First Law of Motion
By Chris Puplava, November 25, 2009
Since the start of the decade gold has been in a strong secular bull market in which it has had only one negative year (2001) while the S&P 500 has had four. Gold’s strong performance has produced a cumulative return of 311.54% for an annualized return of 15.18% per annum this decade. In stark contrast, the S&P 500 has been in a secular bear market in which its cumulative return has been a negative 24.52% for a negative 2.77% annualized return. While gold has had periods of volatility (risk), what the above numbers indicate is that gold has had a superior investment profile relative to the stock market in which it has had consistent positive returns with less risk associated with those returns. According to Newton’s first law of motion, an object in motion tends to stay in motion unless acted upon by another force, all bearish forces have proven too weak to buck gold’s secular bull market, and that trend will likely continue for years to come.
While the books have not yet been closed on 2009, this year is setting up to be gold’s strongest annual performance this decade as the yellow metal is already up 34.37% year-to-date (YTD), besting the S&P 500 YTD performance of 22.78%. While gold’s rally in 2009 has been quite dramatic, the move in gold may continue even higher heading into 2010. There have been three large moves in gold this decade that have come after a consolidation period, with the first being the 2005 rally that carried into the spring of 2006, the second being the 2007 rally that carried into the spring of 2008, and the current gold rally being the third. The 05/06 rally witnessed gold rise 74.93% while the 07/08 rally saw a 57.49% advance in gold. Using the previous two gold rallies as analogs to the present, if gold mimicked the 05/06 rally it would peak at $1,648 per ounce by May of 2010, and if gold followed the 07/08 rally it would rise to $1,484 per ounce by March of 2010.
Source: The Chart Store, Weekly Chart Blog (11/20/2009)
With each of the three major moves in gold one common theme is that it didn’t matter what country an investor resided in as gold rallied in virtually all currencies. This is illustrated below in which the price of gold was deflated by my G10 USD Index, Emerging Currency USD Index, and Asian USD Index, and then normalized to 100 at the start of 2001. As seen in the figure below, gold advanced when priced by each currency index in the 05/06, 07/07, and the 2009 rally. While gold is at a new all-time high priced in US dollars, gold is currently testing the all-time highs when priced by my Emerging Currency Index and the G10 Index, and is still 7.1% below the Asian Index deflated gold price all-time high. The second figure below shows the average of the three foreign currency USD indexes used to deflate the price of gold. The figure illustrates that the returns in gold for a US investor have been more than that of a foreign investor as most foreign currencies have appreciated relative to the USD, with a US investor witnessing a 332.86% return since 2001 and a foreign currency investor witnessing on average a 252.57% return, indicating that nearly a third of the gold return for a US investor has been from US dollar depreciation.
As has been stated in my last two articles in reference to gold, the greatest risk for gold investors is another cyclical bull market in the USD like the 2005 and 2008 advances. While a cyclical bull market in the USD may be the greatest risk for gold, I do not agree with the deflation camp that envisions a huge rally in the USD. The USD is certainly oversold and due for a rally, though I do not believe a sustainable rally for the greenback is in the cards based interest rate differential trends (IRD). Back in 2008 the USD staged a dramatic rally and the USD bears were screaming manipulation and that the dollar’s rally was not substantiated by any fundamentals. In actuality, the headwind that drove the USD down so dramatically late in 2007 and into 2008 was turning into a tailwind and did support the dollars advance. I commented on this back in 2008 with an excerpt from the article below.
The strong rebound recently likely reflects an unwinding of large dollar short positions as well as currency trader’s expectations that the EU is likely to begin lowering interest rates in the near future as the ECB begins to focus on economic weakness rather than inflation. The rate of change in the dollar index bottomed in 2003, more than a year ahead of the first Federal Reserve rate hike, and the recent rate of change bottom is likely discounting a higher central bank spread next year as the ECB and other central banks lower interest rates…
While all the talking heads on CNBC may be jumping up and down in excitement about a rising dollar, they should be careful what they wish. While headline inflation is set to decelerate going forward, the picture in 2009 may see the spillover effects of headline inflation pouring into core inflation. A stronger dollar may come back to bite all the dollar bulls by removing the last pillars of support for our economy and corporate profits. The US dollar has been in a secular bear market since 2002 and we are currently seeing a cyclical bull market counter trend bounce as the rest of the global economies recouple with the US, which is likely being discounted in the currency markets currently. As foreign central banks bring down their interest rates they will near the end point of their easing as our central bank did earlier this year. The point when foreign central banks end their easing programs will likely be discounted in advance in the currency markets, and mark the next leg down in the secular dollar bear market.
One of the theories to explain the fluctuation in exchange rates between currencies is IRD. When rates in the U.S. rise relative to other foreign country interest rates the USD appreciates as investors flock to higher yielding currencies. This is what happened in 2004 and in 2005 as the spread between the Federal Reserve’s target interest rates began to rise relative to other central banks, with the USD Index’s year-over-year (YOY) rate of change discounting this trend in advance as it bottomed in 2003 and then gained momentum in 2004. The YOY rate of change in the USD Index peaked ahead of the IRD and I argued last year that the USD rally was likely anticipating the IRD to improve. As shown below, this is exactly what happened as the USD Index’s YOY rate of change bottomed ahead of the IRD and also peaked ahead of the IRD. With central banks around the world either on pause or beginning to raise interest rates while our central bank has stated it will leave interest rates low for an “extended period of time,” the IRD is likely to fall and act as a headwind and not a tailwind for the USD going forward, with the USD Index potentially taking out its all-time low by 2010. A move to new all-time lows in the USD Index by 2010 would certainly support higher gold price to mimic the measured moves of the 05/06 and 07/08 gold rallies to a price target of $1,484 to $1,648 per ounce, but what then? Would that mark to the top in the secular bull market in gold? The short answer is no!
What has been a constant theme this decade is that the supply of gold has dramatically trailed the growth in fiat currencies all over the world. This was not the case by the end of the secular bull market in gold in the 1970s and early 1980s run in which the USD was more than 100% backed by gold as the price of gold (and thus the value of USD gold reserves) increased well above the rate of the US monetary base. For a 100% backing of the USD by gold, the price of gold would have to rise to $6,888 an ounce! Looking at the percent backing of the USD by gold reserves helps to indicate which is a greater value, the value of the greenback or the value of gold. As shown below, the percent of USD currency backed by gold is currently below even the low point of the 1970s secular bull market starting point, this even with gold now in triple-digit territory and at an all-time high near $1,200 per ounce! Using the same type of analysis on a global perspective, all of the international reserves of the world are only backed by gold in the low double-digits, requiring a gold price of $7,321 per ounce for 100% backing.
Commenting on the theme of gold prices/supply failing to keep up with fiat money printing are analysts from Bank of America which recently put out a report arguing for an imminent rise of gold to $1,500 an ounce. An excerpt from their report is given below:
Bank Of America On Gold's Imminent Rise To $1,500
When EURUSD drops, gold tends to hold its value
So what is driving the correlation between gold and the various currencies? Our analysis suggests that the correlation of gold returns to EURUSD is a lot higher on the upside that it is on the downside (Chart 6). This is a rather interesting development that it is also present in other currency crosses. The simple explanation, in our opinion, is that the supply of money in all currency areas is increasing a lot faster than the supply gold. So the weaker dollar is contributing to push gold prices higher in USD, but the increase in money supply in all countries is driving gold prices in every currency.
Compared to the expansion in the money supply …
In our view, the massive expansion in money supply observed in 2008 represents a competitive debasement of fiat currencies relative to gold (Chart 7). With the exception of the JPY, broad money in local currency expanded at rates between 8.5% for the EUR and nearly 25% for the TRY, compared to an expansion in the global stock of gold of 1.18%. For the time being, however, the rapid increase in real money has not been accompanied by a broad-based increase in consumer prices as the credit multiplier has remained rather muted in most countries…
Any given EM CB cannot hedge against further USD weakness by buying EUR or GBP. This is because there is a significant probability that the ECB and the BOE will have to follow any monetary policy moves by the Fed, as it became apparent during the financial crisis. Then again, if EM CBs come to the conclusion that gold is better value than EUR, the problem of reserve diversification becomes one of game theory.
I guess the mentality of “better late than never” appears to be the attitude of central banks. While gold is already up more than 300% this decade central banks are just starting to be net buyers of gold for the first time since the late 1980s. Referring back to Newton’s first law of motion, it appears the force that has caused the net selling of gold by central banks to net buyers is a concern for the value of the USD ahead. India has already purchased more than 200 metric tons of gold from the IMF and may add further to their recent purchase. Not to be left out, the central bank of Russia added 15.5 metric tones of gold to its reserves last month and has indicated it may purchase up to 30 additional tons by the end of this year.
It’s not surprising to understand why gold is performing so well when reading the recent articles below:
- Gold Sets Record as Dollar Drops, IMF May Sell More to India (11/25/09)
- Payback Time - Wave of Debt Payments Facing U.S. Government (11/22/09)
- Greece tests the limit of sovereign debt as it grinds towards slump (11/22/09)
- Gold strikes all-time high (11/23/09)
- India plans to buy more gold from IMF (11/24/09)
- Russia to Buy Canadian Dollars, Considers Other Currencies (11/25/09)
- IMF Announces Sale of 10 Metric Tons of Gold to the Central Bank of Sri Lanka (11/25/09)
While the price of gold may be reacting to various factors at any given point in time, it is interesting to look at gold’s correlation to different variables to determine what appears to be driving the price of gold currently relative to other rallies. The correlation coefficient is bounded by +1 and -1, with +1 showing perfect positive correlation between two variables in which they are moving in lockstep fashion together, while -1 implies a perfect negative correlation in which two variables move in opposite directions, with values between -0.20 and +0.20 showing weak to no correlation.
Below is a figure that charts gold’s correlation to U.S. inflation using the iShares Barcalys TIPS Bond ETF (TIP) as an inflation proxy, the USD Index, and the credit default swaps (CDS) on euro-denominated 5-Yr UST to serve as a proxy for US creditworthiness risk, with CDS data only going back a year and a half. What is interesting when looking at the rally in gold in 2005 into 2006 is that when gold broke out it was showing no correlation to the USD and the first leg of the rally into 2006 actually witnessed the correlation to the USD show a strong positive correlation, contrary to its normal relationship. However, in the final leg up to the 2006 peak the USD broke down significantly and then became nearly perfectly negatively correlated to gold, indicating the later move up in gold in 2006 was from gold acting as a USD hedge. Also, the correlation to the TIP ETF was falling and becoming negative through most of the 05/06 rally, indicating that gold was not acting as an inflation hedge so some other factor was driving the price of gold higher in the first leg.
The 07/08 move in gold appeared to follow the normal pattern in which gold is positively correlated to inflation and negatively correlated to the USD. Interestingly, while the first leg up in the 05/06 rally saw gold being positively correlated to the USD and the second leg showing gold and the USD being negatively correlated, the opposite occurred in the 07/08 rally. The first leg into the end of 2007 saw gold and the USD negative correlated as one would expect but that negative correlation diminished significantly as gold was acting less as a USD hedge in the latter stage of the advance.
To help explain the recent run up in gold north of $1,000 it appears as though the move in gold is similar to the 07/08 rally where gold is negatively correlated to the USD and positive correlated to inflation. Before gold broke north of $1,000 an ounce gold and the TIP ETF were perfectly uncorrelated (correlation coefficient of 0.0), though they are now perfectly positively correlated (+1) and the weak negative correlation of gold and the USD has increased to nearly perfectly negatively correlated (-1), meaning gold is acting as both an inflation and USD hedge. What is interesting to note is that the correlation of gold to the CDS on 5-Yr UST is rising as it did when gold bottomed in 2008 as it headed from $700 an ounce to over $1,000 where the move in gold in late 2008 and into earlier this year was from gold acting as an inflation hedge and a hedge against the UST (sovereign credit risk) with a weak correlation to the USD.
In short, an object in motion tends to stay in motion and that is certainly the case with gold. The bullish supports for gold are far greater than any bearish factors and even a USD rally may not stop gold as was seen in the 1st half of the 05/06 rally and the 2nd half of the 07/08 rally. Given that the IRD between the US Fed and other central banks is likely to weaken going forward, it is hard to envision a strong cyclical bull market in the USD that would derail gold. As shown from prior gold advances, gold may move close to the $1,500 an ounce mark before this advance is over, and relative to fiat currencies, the secular bull market in gold may continue until gold hits levels as high as $6,888 to $7,321 an ounce. You’ve heard many times over the past year that “the worst is yet ahead” in reference to the U.S. economy or credit markets. Well, in terms of gold it appears that “the best is yet ahead.”
© 2009 Chris Puplava