Issue 43 • September 16, 2009

Gold Soaring on Inflation Concerns? Maybe Not…

In May, when the S&P 500 began to move sideways for a few months, I wrote in Weiss Advice (Issue #25 ) that another market looked ripe for a bull market run.

I pointed out that commodities still appeared to be in a bull market uptrend ... and “specifically, gold hasn’t lost its bull market luster.”

Since then, broad commodity indexes have moved slightly higher and gold has been inching steadily upward since June — trading above the magical $1,000 per ounce level again this week for the first time since its record high above $1,030 an ounce back in March 2008.¹

Many observers point to intensifying fears of inflation as the main catalyst for gold’s rise, since it is considered the “most classic of inflation hedges,” but there may also be a simpler reason why the yellow metal could continue to rally higher in price ... in a word: LIQUIDITY! ²

The Outgoing Tide of Deflation

“Billions of dollars spent by central banks to rescue the global economy from a slump have fueled fears that inflation could rise sharply,” as the Financial Times correctly points out.³

There’s no doubt that central bankers around the world, including the U.S. Federal Reserve, the Bank of England, the European Central Bank and even the People’s Bank of China, have left liquidity taps wide open ... unleashing a gush of monetary and fiscal stimulus in an effort to revive the global economy.⁴

But so far, this liquidity flood has been struggling upstream against an outgoing rip tide of deflationary pressure.

In other words, while central banks print money like mad and shovel it into circulation, much of this cash remains on the sidelines locked up in idle bank reserves or institutional money market funds.

Consumer and business spending has plunged, credit is contracting at a record rate, and savings rates are on the rise. At present, deflationary forces still seem to have the upper hand ... this climate isn’t a recipe for immediate inflation.

The NEW Carry Trade: Sell Dollars to Buy Gold

Perhaps, in time, the “velocity” of this fresh money in circulation will finally pick up and inflation expectations along with it, but not yet and perhaps not anytime soon.

So what is driving gold if not inflation fears, and more important, what forces can push gold prices higher still? Excess global liquidity itself provides a bullish backdrop for gold and other precious metals.

Extremely low interest rates may be making the U.S. dollar everyone’s NEW favorite funding currency ... just as the Japanese yen was the carry-trade currency of choice for many years.

With the Fed funds rate locked in a range of ZERO to 0.25% for almost a year now, the cost of borrowing in dollars is dirt-cheap ... giving the yen a run for its money. The dollar is not only cheap, but worldwide supply is huge, making it easy for global investors to borrow and sell low-yielding dollars to fund speculation in other higher yielding assets.

Excess Liquidity Must Go Somewhere

In a perfect world, most of the excess global liquidity should find its way into productive investments, but the reality is that much of this liquidity will end up as speculative rocket-fuel used to launch other asset classes higher.

This brings us full circle — back to commodities, and specifically gold.

Since central banks opened fire hydrants of liquidity, stock markets around the world have responded with huge rallies. The S&P 500 surged 53% higher in just six months from its March 9 low, to September 9, 2009. According to several measures of “fair value” I watch closely, stocks no longer appear as attractively priced.⁵

Commodities however — and gold in particular — haven’t rallied nearly as much as other assets, like stocks. Over the same six-month period ending September 9, the CRB Commodity Index is up just 21.5%.

In other words, commodities have not overshot to the upside as stocks have done, and may have some catching up to do.⁶

Gold is up just 7% over the same period and may catch up with a vengeance with other asset classes as the tidal wave of excess global liquidity washes into other markets, including precious metals. Not surprisingly, as gold flirted again with the $1,000 mark, other metals including silver and platinum also soared.⁷

At this point, the move in gold may be due more to excess global liquidity, and as a store of real value in a still uncertain economy, rather than an inflation hedge. And the next leg higher in the commodity bull market could see gold in the lead. Stay tuned!

Good investing!

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

¹ Bloomberg: Gold Climbs to 18-Month High as Dollar Weakens; Silver Gains, 9/11/09
² Financial Times: Gold Breaks Through $1,000 Mark, 9/11/09
³ Ibid.
⁴ BCA Research: U.S. Investment Strategy, 9/11/09
⁵ New York Times: Around the World, Stock Markets Fell and Rose, Together, 9/12/09
⁶ Bloomberg market data, 9/15/09
⁷ Financial Times: Gold Breaks Through $1,000 Mark, 9/11/09