The Fall in Gold and Metals Jude Wanniski April 29, 2004

The $14 drop in the price of gold and the slide in industrial metals yesterday was largely attributed to a Reuters dispatch posted on Bloomberg at 10:45 AM. out of Beijing, quoting Chinese Premier Wen Jiabao in a way that suggested a slowdown in China’s economy. Gold already was off $5 at 9 AM, shedding the rest coincident with the China report, and we do believe the fall in gold and the fall in metals were slightly separate issues. Certainly, gold is a monetary metal, not an industrial metal. It primarily reacts to real and imagined movements in the supply and demand for dollar liquidity in the U.S. banking system. The splendid news on corporate earnings and economic growth dominating recent financial reports has been steadily increasing speculation that the Federal Reserve will raise interest rates sooner, not later, and this is enough in itself to increase demand for dollar liquidity.

Part of the decline in industrial metals is in sympathy with the 10% decline in the gold price since it peaked at $430 in February. When gold deflates, commodities that have risen in price simply because of a previous inflation follow suit. Yesterday, Stephen Anderson advised our SSP clients that except for aluminum and forest products, commodity prices now are vulnerable to the renewed deflationary forces at work. The 1.5% decline in nominal prices of equities yesterday can also be viewed as a clearing of some of the inflationary froth in that market.

Gold would have to fall another 10% before it would seriously chew into the real value of equities, which have been reflecting the economy’s healthy expansion. However, a flurry of tax proposals before Congress could fuel this decline if these proposals are passed. Yesterday, the House voted overwhelmingly (by a 323-to-95 margin) to permanently extend the 2001 relief for married couples, and next week it will vote on providing relief from the alternative minimum tax. These votes set the stage for an election-year tax-cutting war that could send gold significantly lower and revive a destructive deflation, unless the Fed took note and switched to commodity targeting.

As for China, Premier Wen essentially announced a bank holiday for the next several days, when lending for the cement, steel and aluminum sectors would be curtailed “in a broad clampdown to stamp out excessive development,” as Reuters put it. China also has issued new land-use rules to formalize Beijing’s recent activity in curtailing new industrial projects that are chewing up its arable land. “We need to take effective and very forceful measures to resolve those problems as soon as possible," Wen said.

Some of these reactions from the government are related to the pressures it has been getting from Washington and Europe as China’s blistering 9% growth rate now is seen to be driving up demand and global prices for all commodities, especially petroleum. Wen is about to embark on a ten-day tour that includes stops in Germany, Belgium, Italy, Ireland and Britain, and he wants to seem helpful as he tries to build on a partnership with the European Union. However, China has been genuinely “overheating” as a result of its dollar peg, which we have pointed out several times in the last several months. Because inflationary impulses travel far more rapidly in China than they do here, the dollar inflation it has been importing with the rising gold price has threatened the central government’s political grip on the provinces. When there is no monetary stability, 1.4 billion people take their own steps to live with the turbulence.

As Wen indicated in his interview, there now is no thought of appreciating the yuan as an accommodation, which is an eminently sensible decision on the government’s part. The 10% decline in the dollar/gold price will travel through the economy just as fast on the way down as it did on the way up, and that alone will take much of the unwelcome froth out of the banking sector. State banks are run by the same kinds of people who run private banks, and when they have more reserves than they need sitting idle, they want to put them to work, whether the collateral is topnotch or somewhat suspect. Remember our savings-and-loan crisis? Penn Square? Continental Bank of Illinois?

For the time being, there is nothing to worry about. In some ways, the decline in gold might even be in time to short-circuit the late arrival of consumer price increases that might force the Fed to actually hoist the funds rate unnecessarily. In our April 15 report, we noted that “In a best-case scenario for the financial markets through Election Day, the news reports on the national economy’s expansion cannot be so rosy that they force the hand of the Federal Reserve at its June FOMC meeting.”

The price of oil still is misbehaving, but we can clearly ascribe that to the deteriorating situation in Iraq and the Middle East. The dollar/gold price decline is a wonderful inducement to the OPEC nations to produce more oil instead of curtailing production, and our guess is that we will see this happening in the weeks ahead. The political strife does place a price premium on crude, as consumers of crude add to inventories just to protect against even higher prices if conditions worsen in the Middle East oil patch. Prince Bandar bin Sultan, the Saudi ambassador to the U.S., can talk openly about how much he would like to help re-elect President Bush by getting oil below $30/bbl. It does help that dollars have greater purchasing power in other currencies and commodities.

A big break in oil below $30, though, will probably require a successful transfer of “sovereignty” to a genuine Iraqi government and a breakthrough in the Arab/Israeli struggle in Palestine. President Bush could get oil to $28 by inviting Yasir Arafat to dinner at Camp David, but as nobody is talking about such a move, we’re stuck with high-priced oil for a while. (I made the point in 2001 that 9-11 would not have happened if President Bush had invited Arafat to the White House, to balance the scales with Ariel Sharon just a tad.)

Please call or e-mail with questions, or with any better ideas on how to sort all this out, especially the latter. For the moment, though, under the circumstances we remain as optimistic that the mess in the world is being sorted out in its own way.

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