We Told You So
Jude Wanniski
January 15, 1997


Memo To: Website fans and clients
From: Jude Wanniski
Re: Gold price

You may have noticed the price of gold falling in the last several weeks. We saw it coming. The following is a client letter our David Gitlitz, who watches these sorts of things for us, sent out in November '96:

November 20, 1996
by David Gitlitz

Despite today's little bounce in the gold price, a short-term response to release of the latest trade figures, we have been persuaded by recent trends that a new gold price trading range below $380 per ounce is being established. This is the first time in nearly two years that gold has sustained trading below that mark. If this is affirmed in subsequent trading activity, it would represent a significant increment of reduced inflation risk to dollar-denominated assets, with highly positive implications on the outlook for monetary policy, bonds and the dollar's forex value.

In a pattern that we've seen emerging for the past several weeks, the market appears to be testing some fairly narrow limits en route to a lower trading range. Since it first dropped below $380 in late September, gold has now twice rebounded to around $384 (most recently, last week), only to quickly fall back again, failing to find support at the higher levels. The activity suggests that at the margin short sellers are driving the market. To this point, they have been covering to take profits when prices reach a certain level (about $378), then reestablishing their positions when it becomes evident that follow-through pressure on prices is weak. As it becomes increasingly apparent that current market conditions offer little opportunity for gains on long positions in gold, selling pressure could intensify, setting the stage for another break below $375 per ounce.

Ours is a somewhat contrarian view. Various technical analysts and chartists see signs in the current activity (what they call a "triple bottom") that a strong gold rally is overdue. They say the selling pressure is being driven by small speculators while large producers and commercial users ("insiders") are building more substantial long positions, pointing to higher prices ahead. Even if true, this is trivial noise given the overwhelming monetary forces at work. Gold's unique place in the market is due to its use as a hedge against the currency's loss of purchasing power, a property replicated by no other commodity. As Alan Greenspan has pointed out, gold has this monetary utility because its annual production is only a tiny fraction, about 3%, of the existing inventory of previously mined gold. Short-term supply and demand factors can only cause blips in the market. A sustained rise in the gold price in dollars, the world's key currency, occurs when excess dollar liquidity seeks a home in a better store of value. The fact that gold has shown no inclination to rally even as industry participants are apparently stepping up their purchases of the metal serves to illustrate the point. If gold was going to rally because of increased commercial demand for the metal itself, it already would have occurred.

Gold's recent behavior has been closely tied to the Fed's conduct of open market operations, especially as the funds rate varies from its 5.25% target. Not that the funds target at any given time represents an optimal balance of supply and demand for dollar liquidity. It doesn't. When the target was cut by point in late January, it produced heightened volatility and a surge in the gold price. An already apprehensive market saw the decision as an aggressive election-year move by the Fed to spur economic activity. The chart, which tracks the price of gold against a 10-day moving average for federal funds, shows the volatility of this period associated with the funds rate falling below target. The combination of a rising, volatile gold price and a funds rate dropping below target tells us the Fed was supplying liquidity in excess of demand at the new rate. The chart suggests that this error was absorbed, moving the gold price back down to its previous range around $385, at least partly as a result of the Fed permitting the funds rate to trade above target for a time. The most recent bout of upward gold price movements came in August and September, when distortions in the Fed's operating procedures appeared to have it accommodating a phantom increase in reserve demand. Since early October, as the gold price has drifted below the $380 mark, funds rate variability has been as low as it has been all year, moving in  a range around a 5.25% mean.

The Fed has thereby managed to achieve relative stability in the funds rate by pursuing a slight deflationary bias in policy. If the gold price continues to trend lower, moving into a range below $375, it will be telling Greenspan he has to lower the funds rate in order to meet liquidity demands. When this sequence develops, we expect it will add to the present bullishness in the credit markets. The past record has been that the best part of the bond market's response to the kind of range-shift in gold prices that we are now witnessing could still lie ahead. That's because periods of shifting expectations also are times of heightened uncertainty. Investors will, on the margin, wait for an easing of uncertainty ~ as indicated by a decline of gold price volatility before increasing their commitments to long-term bonds. Indeed, the gold price move of the last few weeks has been accompanied by a somewhat higher though hardly troublesome level of volatility, which we would expect to see factored out as gold settles into a new range.

No such lags, though, need await a response by the currency markets to the rising confidence in the dollar indicated by the falling price of gold. This week, for example, we have seen the yen/dollar rate move in close tandem with the gold price, rising above 111.5 as gold pushed back below $380. Today's trade data gave dollar bears a momentary opportunity to capitalize on the sentiment in some quarters suggesting that the yen has become undervalued. It appears highly unlikely, though, that a sustainable yen rebound from current levels is in the cards any time soon. With the dollar strengthening in terms of gold, a reappreciation of the yen in terms of the dollar would require the Japanese authorities to engage in a potentially disastrous withdrawal of yen liquidity from the Japanese financial system. We are confident that the Japanese have at least learned enough since the early-1995 yen calamity to avoid that trap.