Gold Speaks--And the Story Is Compelling

Gold, as expected, has lost some of its luster, with prices falling by about $300 an ounce from around $1,900 an ounce in early September to just below $1,600 a few weeks later. (Keep in mind that as recently as early 2002, gold was trading below $300 an ounce, which means bullion lost more in one month than it was worth about nine years ago.) Although gold has recovered somewhat since then--currently trading around $1,681 an ounce --the recent selloff hardly came as a surprise. Previously we stated that gold is a “buy the rumor, sell the fact” commodity, which in the absence of any fears of a new crisis (old ones that resurface tend to get shrugged off) just doesn’t have any reasons to keep rising.

Beyond the price movements, however, gold seems to be telling a compelling story that’s worth listening to--or at least taking into consideration. First of all, gold is signaling that the world is not coming to an end. Yes Euro zone default concerns persist and fears of a double-dip recession are looking more likely to come to fruition. But these are not new fears, which is what gold would need to continue its climb. As far as gold is concerned, the current outlook is for no new cataclysms.

As I put the pieces of the story together, it seems clear to me that gold is also looking farther down the road than most of us, and what it sees isn’t all that bad. It might even be pretty good.

Gold seems to be giving a nod to the Fed’s monetary policies, including its latest move to buy longer-term bonds, instead of launching another round of quantitative easing (QE3). Thus, while the Fed is keeping interest rates low, it has not lowered them any further, which is why stock prices and gold got hammered in September. But that’s not all gold seems to be saying.

Gold appears to be indicating a scenario that will reverse the Fed’s practice of paying interest on reserves that banks have on deposit. Without a return on that money, it will flow out into the economy in the form of increased lending by banks, which will help fuel growth in response to demand. Gold won’t benefit from that at all and, as a result, its price has fallen.

And there’s more to this story as well. Gold’s price drop indicates that we probably will emerge from the economic contraction/recession without hyperinflation. This is where the Fed’s policies really shine. The Fed expanded the monetary base, but not money supply. (Think of the monetary base as cookie dough and the money supply as cookies that get baked. We’ve got a lot of dough in the system, but the number of cookies coming out of the oven hasn’t changed.) In financial terms, the Fed’s actions, including extremely low, accommodative interest rates, increased the monetary base (dough), but banks have not been lending money in a way that increases the amount of money (cookies) out there. The banks would rather keep their dough (pardon the pun) with the Fed to earn interest.

By constraining money supply while increasing the monetary supply the Fed was able to contain inflation. As we’ve written before, although some people complain that the Fed’s actions equate to “just printing more money,” the truth is the money supply has actually stayed at the banks.

Until now, gold has been a beneficiary of the Fed’s actions to keep interest rates low. Unless you were an institution, you had to do something with your cash other than keep it on the sidelines. You had to take a shot, which pushed the price of many assets including gold higher. If you bought gold over the past one or two years, then good for you--you made money. But now the premise for investing in gold has passed its prime.

Gold has a tale to tell these days for those who care to listen. The price is down and that’s basically good news for what could very well develop in the economy: the probability of an ordinary contraction/recession with no downside surprises, the likelihood of no hyperinflation, and an expected change in Fed policies sometime in the future to help increase the amount of money to finance new economic growth.

With gold off its highs, events may prove to be pretty uneventful (barring any sudden, unforeseen crises, that is)--and that’s a story worth listening to.