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“On the other hand, gold’s detractors are just as adamant that it isn’t worth anything. Like John Maynard Keynes, they regard it as a “barbarous relic.” Sure, you can make wedding rings from it, but apart from that it’s useless. At least with copper you can make pipes, and bonds generate an income. But gold is mainly a psychological asset. It’s worth something because other people think it is.”
                                    Matthew Lynn

Commentary & Analysis
Warning: “You are entering the land of extremists.”

No, this quote is not referring to the USA … or it would have read “the land of right-wing extremists.” This quote refers to the gold market.

Here is the long-form quote from MarketWatch:

The problem with gold, for any cool-headed, realistic investor, is that as soon as you start to discuss it, you are entering the land of extremists.

After I read that line I quickly scrolled to the sign-off at the end of the article to see if Jack was the source of this quip. He was not, though I don’t think he could have said it better himself.

The goal of the aforementioned article was to determine if George Soros had properly timed his exit from gold (since his selling of $800 million worth was recently published and heavily circulated.) I suppose Soros has earned some respect from market-callers since he’s done pretty well with some other big bets of years past. But the author, Matthew Lynn, doesn’t appear to think Soros has it right this time; instead he believes a top in gold is at least a year away.

His reasoning: inflation.

Now, I don’t necessarily think Soros’s top-calling will prove perfectly timed; but I don’t necessarily think Mr. Lynn’s reasoning is right, either. Here is the article for reference purposes.

Rising prices – commodity inflation – is said to have been a boon for gold. But commodity inflation has been due in large part to low interest rates that incentivize investors to borrow dollars and assume greater risk in search of greater return. Basically, we’ve seen “inflation” without the typical reactionary rise in interest rates.

What is it going to take to bring interest rates higher? I would say it’ll take rising prices with simultaneous progress in global growth. And if we have those two things, then gold loses some investor appeal because it boasts no yield in an environment of rising interest rates.

Mr. Lynn disagrees in such an outcome for gold; he doesn’t explicitly say whether sustained global growth is a precondition of his inflationary-led blow-off in the price of gold. In fact, he implies the opposite:

Central banks will be forced to raise interest rates — and potentially quite sharply as they wake up to the fact that inflationary expectations are getting out of hand.

And what will happen then? Bond markets will collapse — that’s certain. Equity markets will wobble. The historical record shows that equities are a poor hedge against rising prices, and they usually do poorly when interest rates are rising.

Where is everyone going to flee for safety? To gold, of course.

I’m pretty sure I read somewhere recently that equities are actually a pretty good hedge against inflation. And what about gold as an inflation hedge — has that myth been debunked yet? Have a read of Gold is a “Crisis Hedge” not an Inflation Hedge.

Consider: without global growth it seems more likely that investors will seek gold (versus other commodities) than they would in a world where central banks are normalizing monetary policy. The last few weeks have raised concern over whether global growth can be sustained; it seems we could soon find ourselves in an extended period of sub-par growth.

Right now, I would say Mr. Lynn is right on gold, but for the wrong reasons.

Mr. Soros, on the other hand – is he wrong on gold, but have the right reasons? This from The Alchemy of Finance, referring to the US ahead of the 1987 market crash:

Undoubtedly, our economy was somewhat stronger than had been expected, but the strength was in industrial production rather than in final demand. Commodity prices were rising, encouraging inventory accumulation and raising the specter of inflation. The fear of inflation was more a rationalization for the decline in bonds than its root cause; nevertheless, it served to reinforce the downtrend in the bond market.

Sounds eerily familiar to today, when manufacturing improvements have been cited as the strength in the US economic recovery; and final demand has remained a key concern. And maybe that’s why George has unloaded his gold: gold topped out at the end of 1987 and decline sharply for the next two years.

What is important, as it always is, is the value of the US dollar. It traded inversely to gold from 1987-89, just as it has been doing for the better part of the last several years. So if the US dollar gets a risk bid in the face of a sour global economic forecast where deleveraging from speculative investment reverses the flow of capital, then George might have it right.

But what if the US dollar doesn’t catch this bid? What if it continues its downtrend amidst the “US economic muddle through” scenario of the US dollar smile?

I think gold has more time to rise. But I don’t think it is based on inflationary expectations, per se. I think Mr. Soros is right to be concerned about a shift in capital flows, as gold is very much reliant on dollar liquidity. I just don’t see an end to dollar liquidity … yet.