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A Pause in the Gold Action
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(January 21, 2004) While the bull market in gold pauses to take a breather, let’s take a moment to consider whether gold is a commodity, a currency, or a canary caged in a mineshaft, ready to let us know ahead of time when inflation is on its way.
First off, in gold news we find that the European central bankers will probably renew the Washington Accord, limiting central bank sales of gold to perhaps 400-500 tonnes a year over the next five years. The Financial Times of 1/19 quotes Klaus Liebscher, governor of the Austrian central bank, as being ‘very optimistic’ that a new agreement will be completed sometimes this spring.

“His comments will help to reassure gold investors who have seen the metal’s price rise by 20 per cent in each of the past two years on geopolitical tensions and the sliding dollar,” write Tony Major and Andreas Krosta for the FT.

Central bank selling has for decades been the bane of the gold market, the bogeyman hiding under the bed, threatening to scare gold owners out of their wits. European central banks hold some 16,000 tonnes of the shiny yellow metal, and gold bears and other enemies of gold rather disingenuously call this figure an ‘overhang,’ as if all this gold was precariously poised to come onto the market at any time, crushing the gold price to smithereens.

But, given gold’s performance over the past 2 ½ years, would those bankers really rather hold dollars? The gold that resides in their vaults is probably the strongest currency that they could own. As Leonard Kaplan writes in his “Market Commentary” of 1/19/04:

“Gold, over the past year or two, has been behaving NOT LIKE A COMMODITY, but a CURRENCY….As such, all fundamental factors in this market must be accorded short shrift. It seems that such matters have little material effect. It seems almost unimportant that Indian gold demand fades when prices are high and shines at lower levels. It seems totally irrelevant that the gold producers have repurchased millions of ounces of gold in this market. It appears foolhardy to judge global jewelry demand and make any assumptions. Gold has been, simply, a currency of late. The very facts demand we see it that way.”

Ask any Saudi prince about the value of gold versus dollars. On Tuesday, January 20th, crude oil once again traded for over $36 a barrel, or roughly three times its mid-1990s low price. Of course, back when oil traded in the ‘teens, the Saudis could buy gold, a money that they trust, for under $300 an ounce. Today, with the dollar on the rocks and gold up over 50% in less than three years, those who control the world’s oilfields are not likely to open the spigots and let oil prices, denominated in dollars, fall again.

There is a core relationship between the price of oil and the price of gold, an equation that will hold as long as the value-minded House of Saud rules the main source of the world’s oil. In short, the Saudis own oil, which is a real commodity, of finite supply. But in today’s world, oil is sold for US dollars. Dollars are just an abstract medium of exchange, and a weakening one at that. So in the Saudi mind, how many dollars it takes to buy their oil is determined by how much gold those dollars can buy - for gold, like oil, is a real commodity, of finite supply and eternal value.

Sowhich came first, $30+ oil or $400+ gold? Are higher gold prices the cause of higher oil prices? Yes, because the Saudis sell their oil for dollars but they always keep a sharp eye on what those dollars will buy IN GOLD.

Conversely, are higher oil prices also the cause of higher gold prices? Again, yes, because more expensive oil will increase the costs to run our cars, heat our homes, bring all those goods we enjoy from China, deliver them in US, and so forth. This creates further price increases in everything we buy, a syndrome which goes by the old-fashion term “inflation.” And inflation is a sign of a weakening dollar so obvious that even Joe Investor can’t ignore it, which means that people will eventually seek out inflation hedges, such as gold.

Increased demand for gold, particularly in the US investment community, will be the key. When that demand heats up, gold prices in US dollars will soar. Which means the Saudis will want more dollars for their oil, because it will take more dollars to buy the same amount of gold, which means more inflation, and so on and so forth.

It’s rather dizzying to consider where this nightmare cycle of inflation, higher gold, and higher oil prices could lead. Which is why the US Treasury and the Fed have always campaigned to treat gold as an ugly stepchild, an obsolete commodity vastly inferior to the mighty US dollar as a reserve currency and store of value. No Treasury, Fed, or White House official wants to see the total disintegration of the dollar happen while they’re in office, even though in their heart of hearts they would each one of them admit that, yes, the fiat dollar is going to implode eventually, on someone’s watch, but just please let me retire before that happens…

George Melloan wrote an article in the Wall Street Journal of 1/20/04 entitled “Promises, Promises, But Who’s Minding the Budget?” A day before President Bush’s State of the Union speech, he ended the article with this:

“Mr. Bush has earned the right to brag a bit about his record tonight. But will it look as good if the dollar collapses and inflation hits before next November?”

 

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