The Puzzle: Gold, Bonds and Y2K Jude Wanniski May 27, 1999

I have been puzzling about the anomalous behavior of gold and bonds for most of the year, rejecting all possibilities that are inconsistent with our analytical model. The idea that gold sales by central banks are causing gold's decline in the context of supply and demand for the species is one that has never worked for me. There is so little gold in the world that it doesn't much matter whether it is held by a government or by the 6 billion souls on the planet. (As a reminder, the 125,000 metric tons in existence would be only enough to build three feet of the Empire State Building at the base.) What is so puzzling as gold dips below $270 -- which it has not seen since the earliest days of Paul Volcker's tenure at the Fed -- is that gold signals a further monetary deflation, yet the 30-year bond discounts an inflation ahead. The fact that oil prices have bounced back from their lows is something we did expect. This, because oil was driven down both by the dollar deflation and its excess supply as OPEC countries produced more as prices fell in order to meet their dollar obligations. Also, Iraq produced more to hit the dollar amount permitted under the United Nations sanctions.

I've had the queasy feeling all during this period that the anomaly is tied to Y2K, and now I am confident enough that it is that I could attempt to explain why. From our first Y2K report early last year, "Y2K Opportunities," 3/31/98, we have related the potential chaos that Y2K could cause in the current global non-system of floating currencies. Until now, I've not related the gold market to the problem because any increase in the demand for the currency component of dollar liquidity automatically would be supplied by the Federal Reserve. My mistake was in not relating the liquidity component of bank reserves to the decline in gold. If this demand were not met because of a prospective tax cut, for example, there would be no reason for the long bond to react adversely. The gold price would decline, but so would the bond yield. The Federal Reserve is a major problem these days, as Chairman Alan Greenspan totally dismisses the gold signal and focuses entirely on the diminishing labor pool as a potential source of "inflation." Even if there are interest-rate hikes for this reason, they should not affect the price of gold. The Fed raised the funds rate six times in 1994-95 and the gold price did not budge from its $385 plateau. There is no reason to believe the Fed's bias has caused gold's decline.

The missing piece hit me first as a result of Credit Suisse First Boston's "sell" recommendation last Friday on four international money-center banks -- because of analysis that suggests Y2K will leave them holding the bag on non-performing loans in the developing world. This was the first call of its kind relating to Y2K, as opposed to the general warnings of Ed Yardeni and others. CSFB's call was correct, we think, partly for the right reason. Our Y2K clients have been getting weekly reports on the problems abroad that will impact us here. Yesterday, though, I talked to a Wall Street friend who is in London on business. When I asked about the Y2K view from London, he said his industrial clients are placing orders here this year for shipment of inventory they will not need until 2000. This is because they expect Y2K to cause problems at customs, with government computers on the fritz. This is something that had not occurred to us, but is consistent with patterns of date-related failure at government databases thus far.

This, though, would explain the increased demand for dollar liquidity in a way that is separate and apart from the bond market. What clicked into place was a reminder that the world has little use for gold as a store of value as we head into Y2K but an increasing need for the dollar as a medium of exchange. At the margin, the economy will continue to expand as inventories build in advance of Y2K, but next January the market has to begin discounting steady increases in the unemployment rate. If the impact on the economy is small, there still will be surplus inventory to run down. To the degree it is greater, a surplus in dollar liquidity in the form of bank reserves will mushroom. At the very time the Fed should be reeling in that surplus, the rise in unemployment will turn its current model toward monetary ease. Having abandoned gold when he should have clung to it, Greenspan will find it politically impossible to argue for a tightening of monetary policy early next year when everyone will be screaming for monetary ease to inflate the economy back to health.

At our Polyconomics conference in late February, I told Commerce Secretary Bill Daley that I find nobody in the government who understands the Y2K threat to the entire world's financial system that is due to floating exchange rates. I explained that there are at least a trillion contracts made every week in the world -- and a trillion liquidated. These occur in more than 150 currencies, and the only way the chaos can be managed is because of the development of high-powered computers. If only a fraction of those computers breaks down, a fraction of a trillion is a big number. Forget the delivery of actual physical goods. Think of the fact that the world economy is held together by trillions of PROMISES to pay claims on resources upon receipt of resources. This is why I told Secretary Daley he had to begin thinking of advising the President to fix the dollar/gold price before we hit Y2K, which would permit all the nations of the world to link into an anchored dollar in order to weather the Y2K storm. The answer to computer chaos has to be simplicity. Greenspan knows my argument too, but unless he gets an order, he will play dumb about Y2K and continue saying nobody should panic in advance -- as if that were the problem.

I'm not yet ready to certify that this explanation is exactly correct, because it needs more thought. But it is ripe enough for me to share with you now. If the market is going to assume the Greenspan Fed is going to react as foolishly toward a declining economy in January as it is to an expanding economy now, it makes sense the long bond has to be discounting an inflation next year. The gold price is a spot price, in the sense that it will not climb now to discount an inflation next year. The job it does best is signal error in the supply of dollar liquidity, which explains its decline in the context of the market's best guess of what to expect as we close upon the end of the year. As we approach the end of the year, there of course will be fewer orders placed for delivery before the end of the year, because the inventory build-ups then will be in place. That's when to expect a rise in the price of gold, as surplus liquidity appears in the system, with the Fed politically powerless to mop it up.

The implications of my insight, if it is worth being called an insight, are bearish only if not acted upon. The problem will be a continued general unwillingness by the political class to face this problem directly. When I explained it to Secretary Daley, he asked if it were possible to fix the dollar/gold price temporarily , and I said of course that could be done. The President need only sign an executive order requiring the Fed to replace the unemployment signal with the gold signal, at no less than $300 an ounce. The lower the gold price as we go through this part of the cycle, the less appropriate it will be to have it so far from the average level of dollar contracts made over the past dozen years, at close to $350 an ounce. I've made the same argument to Senate Majority Leader Trent Lott, who does not have the time to think it through, I suppose. I've also made the argument a number of times to Sen. Robert Bennett [R-UT], chairman of the Senate Select Committee on Y2K, to Jack Kemp of Empower America, and to former Vice President Dan Quayle. The closer we get to July 1, which marks the midway point in this penultimate year, Y2K anxieties should produce political leadership somewhere or other, perhaps from these ranks. Meanwhile, check out the most apocalyptic of all the Y2K websites, that of economist Gary North, an economist who now lives deep in the Alabama woods, waiting for the Millennium at www.garynorth.com .