The Gold ‘Bubble’

Gold is off today, currently trading in the $1750 area, down over 5%, closer to 6% at its lows intraday. Given that we saw $1917 earlier this week the usual folks are out declaring that this is the end of the ‘bubble.’  The same bubble that has been existent since $500 and lower. CNBC has basically been in party mode over this. Of course, nothing has been mentioned of the margin hikes that have been instituted at exchanges around the world, but that isn’t surprising given the anti-gold bias in the mainstream. Even if these margin hikes had not been instituted, it would be wrong to declare that gold is in a bubble.

Of course, not everyone agrees. In fact, most don’t.

Gold is not money and has no investment yield and in fact incurs carrying/storage costs. With the 10 year US treasury rate at 2 percent and storage cost of 1-1.5 percent this implies an annual opportunity cost of 3-3.5 percent.

For starters, Gold is money. The fact that governments have legislated it out of everyday transactions doesn’t change that fact. We’re in the midst of a 40 year experiment of commerce without gold – hardly a statistically significant sample size when we’re dealing with 2000-3000 years of human commerce with gold.

The next major issue with the quote is the fact that a major component is missing from his analysis of the 10 year Treasury – the inflation rate. According to his calculation of opportunity cost, you are giving up 3.5% by buying gold instead of the 10 year. When you add an inflation rate that is officially 3.6% year over year, your opportunity cost becomes 0%.

The main factor in determining the fundamental conditions of the gold trade is the real interest rate. When real interest rates are low to negative (usually below 2%), bullish conditions for gold exist and money flows into it in order to maintain the purchasing power that is dwindling from paper currencies in that particular moment. When real interest rates are above 2%, the opposite is true. What people are missing is the fact that gold IS a form of money. And money is a commodity that is always in demand by various people for various reasons, but central to all of them is the fact that the money must maintain its value over the period one wishes to hold it. During periods when the real rate is sustained above 2%, paper money provides this store of value and therefore is preferred over gold. During periods when the real rate is sustained below 2%, gold is the form of money that provides this store of value. A quick peek at where real rates stand, tells us where we are:

As you can see, we’re in a period in which real rates are sustained in negative territory. You can see that it has been below that 2% mark for the vast majority of the decade, with two brief exceptions. It’s no coincidence then that the bull market in gold that began in 2001 had two major corrective periods – 2006/07 and 2008/early 2009 as real rates spiked positive. That they didn’t stay there meant that those were corrections in the gold bull market as opposed to a reversal. The bear market of 1980-2001 in gold saw positive real rates virtually the entire time, mostly in the 4-5% area and above. Bernanke has told us that we’ll see zero interest rate policy for at least two years, meaning that real rates are going to stay negative for the foreseeable future. As long as this continues, gold will continue to be  in a bull market as opposed to ‘one of the great bubbles of our time,‘ as Dennis Gartman stated on CNBC earlier today.

I suspect he’ll be changing his tune in the coming months.

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