Gold and Bonds Jude Wanniski December 10, 2001

The gold price has retraced the entirety of its post-September 11 surge, and there is little macroeconomic reason for it to move lower. There are several such reasons why it might move back up, though. At $272 per ounce today, it is still $20 above its low for the year, but that came when the prospects for supply-side tax cuts were at their peak. In other words, if the economy were trying to expand even faster because of lower risks to production and trade, and the Fed were not supplying the liquidity demanded, the dollar would be even scarcer relative to gold. Gold at $250, then, would make sense. There is now, though, almost no chance of tax cuts this year in Congress. And as the economy continues to deflate inch-by-inch, tax revenues will head further south at all levels of government. Tax cuts now booked will be suspended and some state and local governments will have no choice but to raise tax rates in 2002. The dynamic suggests an upward creep in the gold price over the coming months (perhaps to $280 or so), as long as the government and the Federal Reserve remain immobilized in the face of the deflation.

There is always the possibility, of course, that as it becomes clearer there will be no "rebound" in the near future, the White House will decide to actually do something to end the deflation process. We cannot put a high probability on that because the alternative would be to blame the economic problems continuing into 2002 on the Democrats, for not passing the President's "stimulus" plan. This would not lead to any productive policy change. If by chance reason should win out over politics, the line of least resistance would be a joint "reflation" with Japan. The deflation in Japan is one that does bother the administration, which has dispatched high-level officials to Tokyo urging domestic economic expansion several times. Early this year, the O'Neill Treasury advised monetary ease in the land of near-zero interest rates, but made it clear it could not countenance a weaker yen. Last week, Deputy Treasury Secretary Ken Dam went to Tokyo himself to say it would be just fine with Uncle Sam if they eased monetary policy, perhaps wanting them to get the message that it would be all right if the yen weakened. It has been doing that anyway, going to 126 to the dollar from 120 in recent weeks. That puts the yen/gold price at 34,000 per gold ounce -- though it really should be over 40,000 to break the deflation process. Such a level would be hard to maintain because U.S. automakers and other manufacturers are wary of a more competitive Japan. The answer, as I explained to Treasury Secretary Paul O'Neill last March, is a joint reflation.

What about bonds? At 5.58%, the 30-year Treasury seems awfully cheap in the context of gold at $272. There may some technical reasons why the yield has climbed so high when dollars that pay no interest at all are gaining in purchasing power just sitting under mattresses. Also pressuring bond yields is the expectation that a strong 2002 economic bounceback would be met with a higher fed funds target. Eurodollar futures continue to price in significant rate hikes in the second half of 2002. In this morning's Wall Street Journal "Outlook" column, Bernard Wysocki Jr. says there is no shortage of cash in the economy: "A mountain of money is building in American households. Nearly $4.29 trillion is sitting in consumer money-market funds and various U.S. savings deposits. These liquid assets, in many cases earning just 2%, have grown at a tremendous rate recently and are up 21%, or by $700 billion, just since the beginning of 2000." What the WSJ does not understand is that six months from now dollar prices of goods and services will be lower, catching up with commodities, so there is no motivation for individuals to invest in equities tied to the prices of goods and services. Just sit on the cash. The NYT had a business story last week about how happy Japanese consumers now are that their mountains of yen are able to buy up stuff so cheap in the malls and restaurants.

The chief risk to the long bond at this point may be terrorism. What happens if another terrorist crisis comes like a bolt from the blue? The Federal Reserve has no mechanism for mopping up the flood of liquidity that would result. Gold briefly jumped above $290 before it became clearer there were no other WTCs on Al Qaeda's program. If a new wave of terrorism developed, gold could shoot higher again -- perhaps quite a bit higher. The effect on global commerce would be more severe, increasing the risk that any gold spike into inflationary territory might be sustained.In 1982, when we had the monetary deflation that grew out of the Reagan tax cuts and the Fed's concurrent struggle to bring the Carter inflation under control, there was also a mountain of cash under the mattresses. In the Wysocki "Outlook" column, he mentions a chart that Gary Thayer of A.G. Edwards developed for that period, showing money-market balances growing to more than 20% of NYSE market capitalizations. It's back to 20% now, up from 13% a year ago. When the deflation ended in 1982 -- as the Fed was forced to flood the system with liquidity to buy Mexico peso bonds -- the dollar/gold price shot up from the low $300 range and did not reverse that trajectory until it edged over $500 in February 1983. Fears that this "inflation" would kill the long bond, which already traded at a lofty 14% in those days, were groundless. The entire financial system was suddenly in happier condition and the bond yield fell to 10.5% while gold and equities climbed. In 1983, gold receded to $420 and the long bond yield trended up a bit.

While we sit around waiting for the economy's verdict on 2002, it would be helpful if Treasury did take a look at how it might manage policy when it is finally okay for Paul O'Neill to take over the economic helm from Larry Lindsey. He might not simply want nature or the market to take its course if there is really bad news coming from any direction. A better plan would be to make sure all that liquidity does not turn all at once from deflation expectations to inflation expectations, but to consider the option of stabilizing gold at some reasonable point and letting the markets know about it. All things considered, about the only classes of dollar assets that seem tilted in the right direction are bonds and gold.

P.S. The Wall Street Journal editorial page continues to beat the drums for war with Iraq. This morning's offering is by Khidir Hamza, described as former director of the Iraqi nuclear weapons program, who defected to the U.S. in 1995. Hamza asserts that Saddam has sufficient low-grade uranium to make enriched uranium capable of fueling three nukes. He also says Iraq has designated an area for testing nukes. What he does not tell you is that to get the enriched uranium from the 400 scattered sites where it is hidden requires individual cyclotrons and massive sources of electrical power at each one, and there is no way to keep these hidden. The International Atomic Energy Agency has looked at sites suspected of hiding clandestine nuke operations and have found none.