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Is Gold Really “Tarnished” by its Recent Correction?
As the first quarter reached its rather boring conclusion – most major stock indexes were up about 1% – The Wall Street Journal reviewed gold’s recent correction in a March 28 article entitled “As Broader Fears Fade, Gold is Tarnished: Investors Pile into Riskier Plays as Ukraine Tensions Diminish, Fed Signals Interest Rate Increase; Why Invest in Gold?” We’ll examine their rose-colored scenario of a risk-free planet in a minute, but first let’s look at the “tale of the tape” at the end of the first quarter of 2014:
Precious Metals: First Quarter Performance
Source: Kitco.com, based on London’s afternoon price fix
Gold and the other precious metals beat the stock market indexes by a long shot in the first quarter, but that’s not the most relevant comparison. We have long said that gold does not compete with your stock market allocation. Gold is an alternative to cash. Short-term interest rates in the U.S. are still 0.0% to 0.25%, so there is no meaningful return on short-term cash – and the value of the dollar is slowly falling:
Of course, the dollar managed to beat some troubled currencies, like the Argentine peso (down 22.7% to the dollar) or Russian ruble (down 6.5%), but that brings us back to the Wall Street Journal’s views about the decline of gold, based on (1) the “easing of tensions in Ukraine,” (2) the gradual end of QE through “tapering” and (3) a continued economic recovery, giving the Fed an excuse to raise interest rates.
The Three Reasons for Gold’s Latest Decline Could Backfire at Any Unpredictable Time
With Russian troops poised on Ukraine’s border, it’s hard to argue that tensions in Ukraine have eased. Ukraine is the traditional bread basket of the old Soviet Union, but more importantly it is the conduit for Russia’s massive exports of natural gas to Western Europe. Any interruption of that flow could send fuel prices rising, contributing to inflation, a traditional engine for gold’s growth. In addition, any further annexation of Eastern Ukraine through threats or violence could send gold up as a crisis hedge.
The second cause of gold’s decline, according to the Journal story, is Janet Yellen’s surprising announcement after the last meeting of the Federal Open Market Committee (FOMC) that the Fed might begin to raise short-term interest rates “about six months” after the Fed stops tapering their monthly quantitative easing. If the Fed continues to taper by $10 billion per month, the tapering might end by October 2014, which implies the possibility of a small increase in short rates about a year from now!
There are quite a few waffle words (like “if” or “might”) in that paragraph. A lot can happen in the next 12 months to derail Ms. Yellen’s assumptions about an untroubled economic recovery, with constantly low inflation, no decline in bond prices as yields rise, no spike in the federal deficit as a result of rising debt service, no further decline in the dollar, and no serious slowdown in GDP growth statistics. Any reversal of Yellen’s rosy scenario could send gold back up on its long-term (since 2001) bull market.
In addition to Ukraine and the Fed, the Journal says “a spate of good economic news has freshly undercut the rationale for owning gold.” But we mustn’t forget that Janet Yellen is a “data junkie.” Between now and April of 2015, hundreds of new economic indicators will be released. Any sign of an economic slowdown could cause the majority of “doves” on the FOMC to argue for a slowdown in tapering and a delay in any rate increases. Already, this is the slowest post-war economic recovery – 2.3% average annual growth vs. 5.2% in the 1980s recovery – so you can’t argue that this recovery is very robust.
With the federal debt rising rapidly, the U.S. economy could slow drastically if the Fed raises interest rates too soon, increasing the cost of servicing the massive U.S. debt, now standing at $17.55 trillion. Due to millions more Baby Boomers retiring, claiming Social Security and other entitlements, federal deficits will increase, perhaps by half a trillion per year over the next decade, to perhaps $23 trillion in 2024. According to a new study by the Congressional Budget Office (CBO), the costs of servicing the rapidly-rising load of federal debt reached $415 billion last year and could escalate to $880 billion per year by 2024 (accounting for 23% of the entire federal budget), meaning that one year’s interest payments in 2024 will be 50 times larger than the current NASA budget or 105 times the budget for the FBI.
Gold Fundamentals Improved in the First Quarter
While the long-term looks good for gold, most traders are looking at a short-term horizon. That’s why it’s encouraging to many gold investors to see a gradual increase in gold demand during the first quarter.
Chinese demand is up rapidly in 2014. Since the Chinese New Year fell on January 31 this year, some analysts feared a slowdown in gold demand during February, but February’s demand was much stronger. February’s demand was 3.9 tons per day, or 44.4% greater than the 2.7 tons-per-day average in January:
In other Asian nations, demand is also rising: South Korea opened a new gold market, called the KRX, and Singapore opened a 600-tonne silver vault, to meet the rising demand for secure silver storage.
Central Bank Buying Continues: Given the decline in gold last year, it’s encouraging that central banks continued to buy gold, with very little selling. This year, in late March, the Central Bank of Iraq said that it bought 36 tonnes of gold, more than doubling its previous holdings of 27 tonnes at the end of 2013.
Some Big Global Banks are Turning Bullish: In late March, Japan’s Nomura Securities turned bullish on gold, upgrading its projection for 2014′s average price from $1,138 to $1,335. Nomura sees gold at $1460 in 2015, saying “Like a phoenix regenerating from its ashes, cyclical gold appears set to recover.” In addition, Hong Kong’s HSBC now projects gold to reach $1,390 by the end of this year.
Gold Supplies are shrinking: Jim Cramer said on CNBC in late March that the market overreacted to Yellen, ignoring supply data: “When you read the actual 10Ks of all the gold companies, they’re all having trouble finding gold. The supply of gold is not coming out of the ground as it used to. Even Randgold, which has got the best holdings worldwide, they’re having trouble producing a lot of gold.”
Dennis Gartman said basically the same thing, also on CNBC: “Beginning five and six weeks ago we started to see a lot of the mining companies-even the largest- begin to curtail production. That’s always a sign of an end of a bear market. When senior management at the largest gold mining firms throw their hands up in dismay and begin curtailing production, usually within weeks the lows are going to be found. Decision by committee is always that way. It’s slow; it takes time; and it’s always late.”
When you look at all the evidence, maybe gold is not so “tarnished” after all. The good news is that any correction such as we saw in late March gives investors more time to accumulate gold at bargain prices.