Gold: 'It's a bargain at $930 an ounce'
The bullish outlook for gold rests on the increasing likelihood of accelerating US inflation.
By Jeffrey Nichols
Recent gold-market developments and technical price action – along with broader economic and financial-market developments – suggest gold is bracing for a resumption of its long march upward and a retest of its historic high in the months ahead.
First and foremost, the bullish outlook for gold rests on the increasing likelihood of accelerating U.S. inflation in the years to come – and an associated unprecedented rise in investor demand for the yellow metal.
This nascent inflation has not yet been reflecting in world financial markets. But, judging from anecdotal evidence and the financial press – and the warnings of a growing number of institutional investment managers – we believe a gradual, subtle, but important, upward shift in inflation expectations is already under way.
Inflation doves (and others fearing imminent deflation) point to the currently low, almost negligible, rates of consumer price inflation and the narrow interest-rate spread between ordinary US Treasury securities and US Treasury Inflation-Protected Securities (TIPS) as evidence that inflation and inflation expectations remain subdued. This – along with other important factors that we'll discuss in subsequent posts – has helped keep gold prices down in recent months.
We think those looking at the US Consumer Price Index are focused on the wrong inflation indicator. Instead, a look at the gross domestic product price deflator, a broader, more reliable, and less volatile inflation indicator – rising at an annual rate of 2.9pc in this year's first quarter – should be enough to put fear in the hearts of economic policy-makers . . . but, as far as we can tell, they're looking at the CPI and still worrying more about deflation.
Importantly, in our view, if only a small percentage of investors become worried about inflation, gold could, and likely will, benefit long before any sign of a broad-based rise in inflation expectations appears in the interest-rate differential between ordinary Treasury securities and TIPS, the so-called TIPS spread.
Because of the relative size of the markets, a small shift of investor interest toward gold can have a magnified effect on the metal's price . . . but the same small shift in interest away from ordinary Treasury securities in favour of TIPS may have no noticeable impact on relative interest rates between the two types of securities.
Similarly, even a small reallocation of investment funds away from equities or corporate bonds or other "conventional" assets because of rising inflation or inflation expectations (or for any other reason) into gold may be a big deal for the gold market without producing much of a negative effect on other asset markets.
In other words, by the time the broad financial markets register a worsening of inflation expectations gold will have already made a major move to the upside. It provides an early warning or leading indicator of inflation, signalling the coming acceleration long before financial markets begin to quiver.
Fuel for the Fire
As sure as night follows day, the Federal Reserve's purchase of bonds and home mortgages and the resulting rapid increase in bank reserves (quantitative easing in Fed-speak) – unless soon reversed – is underwriting a coming acceleration of inflation.
And, with a consensus in Washington and around the country that the quickly expanding Federal government deficit should be financed by central bank purchases of Treasury securities, there seems little likelihood that quantitative easing will be replaced with quantitative tightening until well after inflation has accelerated to disturbingly high rates.
President Obama's own Office of Management and the Budget (OMB) now estimates a Federal budget deficit of $1.84 trillion for the current fiscal year ending September 30. This is equivalent to 12.9pc of the overall economy or gross domestic product – and, by this measure, the biggest deficit since World War Two. Early estimates for next year put the deficit at 8.5pc of GDP.
Many economists generally consider that a country's deficit should not exceed three pc of GDP. Whatever the appropriate ratio, for sure this year and next, the Federal government deficits will remain beyond the norm and will require massive Federal Reserve purchases of Treasury securities in order that interest rates remain low enough to accommodate economic recovery.
Jeffrey Nichols, is managing director of New York-based American Precious Metals Advisors
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