As if we didn’t have enough to worry about…
The chart below illustrates a troubling trend that has developed over the last few months. Since late October, the price of gold has trended higher (top panel of graph). This is in defiance of several traditional relationships — gold’s move has been divorced from the general downtrend in commodity prices (middle panel, Reuters Jefferies CRB Index). Gold’s rally clearly was not prompted by any dollar weakness (bottom panel shows a sideways US Dollar Index).
I rarely pay much attention to gold — it’s historically been a poor long-term investment, has a negative yield due to storage costs, and has no more inherent value than a paper currency. For decades, the goldbugs whom I’ve encountered have always struck me as a “save your Confederate money, for the South shall rise again” bunch, forever longing for a different time and place. However, gold can be an important barometer — and it is speaking to us now.
But what is the message? There are several possible intepretations. There have been no particular supply disruptions, so the real key is gold demand. Demand for the metal traditionally falls into three categories: industrial, jewelry and investment. Unfortunately, the supply/demand statistics provided by the World Gold Council have not yet been released for the 4th quarter, so we can only speculate. Industrial demand trends had been weak through September, and likely weakened further into the 4th quarter as the global recession deepened. Jewelry demand was surprising strong last year, but the category is misleading as some of the demand is not for the purchase of gold jewelry as a luxury good, but rather as investment (much of the world prefers this in jewelry form — all the better to use as “flight” capital — my own grandparents, fleeing Nazi Germany, survived for a year on the sale of an emerald ring).
The rise in gold most likely reflects investment demand (some of which spills into the jewelry category). It should be noted that gold has been largely unimpacted by the institutional commodities-as-an-asset class fad that had such a large impact on other commodities (see this earlier post). Although gold is a component of most popular commodity indices, it is a relatively small weight relative to the size and depth of the physical gold market.
Buying gold for investment may have made great sense in the 3rd quarter as a hedge against a systemic meltdown of the financial system. But in the period in question, (the chart shows 10/24/08 to 1/20/09) systemic risk was lessening. The TED Spread, by comparison, a measure of financial system instability, fell 165 basis points over the period. Other measures also reflect declining risk of a systemic meltdown. So why is investment demand for gold still rising?
The best interpretation for the strength in gold appears to be rising concerns over currency devaluation. It may be no coincidence that the gold/commodity/dollar relationship evidenced above began shortly after the approval of TARP and the growing political consensus for a large stimulus package. Yesterday’s S&P credit downgrade of Spain (and of Greece last week), may be the first clear indication that the global response to the financial crisis is degrading currencies. This would be inflationary down the road of course, but may not appear yet in the pricing of other inflation sensitive measures like TIPS due to heavy distorting factors in that market.
The proposed government remedies for the recession assume that the fiscal and monetary stimuli can be reined in as soon as inflation appears on the horizon. From a fiscal policy standpoint, this would require politically unpalatable tax increases and spending cuts. While the independent Federal Reserve can react more nimbly and raise rates aggressively, the Fed has heretofore had limited success in knowing when to switch direction. At the end of the day, the message in gold’s rally may be that neither Congress nor the Fed can be counted on to show such flexibility and foresight.