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May 10, 2004

Interest Rates and "The Death of Gold"
by John Hathaway

According to the Financial Times, "the end of gold as an investment has come a little closer." The op-ed writer reached this conclusion in a 4/16/04 editorial as he pondered the significance of the withdrawal of NM Rothschild from gold dealings at the London Fix and the contemplation by Bank of France officials of reserve gold sales. The writer also counseled that "gold is now a rather risky investment with a nil or low return." Given that the global macro environment is now characterized by "low inflation" and that "independent inflation-targeting central banks are the norm", the risk is negligible that governments will debase the value of "fiat money" in pursuit of their policies.

The prospective investment return offered by gold is an especially timely subject, now that Chairman Greenspan has suggested that risk-free interest rates may actually begin to rise from the current "emergency" 1% 46-year low. The unique attribute of gold is safety. Its free market price is a function of the level of comfort investors have in financial instruments that offer an investment yield, but are less than perfectly safe. For the first time since the secular bear market in financial assets commenced in 2000, there is a prospect of rising interest rates, and possibly for a "considerable period of time." Does this mean a new world for gold?

How does gold do in a period of rising interest rates? The casual and perhaps superficial answer, and the one already reached by supposedly savvy street-smart traders over the last several weeks, is that it does poorly. The recent precipitous 11% decline in gold prices from $430 to $385 suggests that the fund managers, TV commentators and traders dumping gold were collectively reading from the Summers-Barsky script (the 1988 thesis by former Undersecretary of the Treasury and current President of Harvard Lawrence Summers). That paper, "Gibson's Paradox and the Gold Standard" posits that the price of gold must be inverse to the return on financial assets:

"The willingness to hold the stock of gold depends on the rate of return available on alternative assets. We assume the alternative assets are physical capital and bonds."

In his paper "Gold 2002: Can the Investment Consensus Be Wrong? The Summers Barsky Gold Thesis" Peter Palmedo of Sun Valley Gold demonstrated that the weekly price fluctuations in gold were almost entirely (88%) explained by the stock market. Notwithstanding the covariance of both in 2003, it is a matter of common sense. Expectations for good returns on financial assets put gold in the doghouse. However, losing money in stocks and bonds, especially the expectation of more of the same, drives investors to consider the merits of safe havens including cash, T-Bills, and gold.

The residue of high investment expectations built up in the previous bull market, even though the S&P remains 22% below its all time peak four years ago, occludes the merits of safe haven investing. The survival of optimism in the aftermath of the dot com crash is a testament to the resilience of institutional and popular memory as well as to the inherent difficulty, at the broadest cultural levels, of recognizing and adapting to new realities. In addition, high hopes have been sustained well beyond the norm by the Fed's stance of aggressive ease. Almost free 1% money (and the promise of more) sustained the illusion of positive returns by allowing carry trade artists to craft "new" investment products built on nothing more than speculative leverage. The reflation trade, which centered on "hard assets" of any kind, was a corollary of the Fed stance, and explains both the speculative excess in base metals as well as the temporary misperception of gold. It also explains why 2003 provided an exception to the rule that gold prices tend to vary inversely with those of financial assets.

While a rise in interest rates might be presumed in the popular media to be theoretically bad for gold, it is more important to ask and answer several related questions before jumping to any particular conclusion. First, is the prospective rise in interest rates the beginning or the end of a process? Second, are the increases in nominal interest rates identical to real interest rates? Third, and most important, will the interest rate increases be favorable or adverse for the returns on financial assets?

The next interest rate increase will, it can be stated with confidence, begin rather than complete a process. How far must the Fed raise interest rates before monetary policy can be considered neutral rather than aggressively accommodative? Assuming, for the moment, that measured price inflation is running at 1.7% (latest 12 months), most would put a "neutral" Fed Funds rate at +/- 4%. Should measured inflation begin to rise, as it did most emphatically in the most recent Consumer Price Index (CPI) report and as it is doing on an anecdotal basis almost everywhere, to what level would short-term rates have to rise in order to be considered restrictive? Almost certainly, that number would be substantially above 4%. It does not seem far-fetched to suggest, considering the level of existing and prospective budget deficits, the unprecedented build up of debt, the open-ended nature of American military commitments, and the disinclination among political leaders to restructure Medicare and Social Security entitlements, that the year 2004 bears a strong resemblance to 1968. In that year, the DJII peaked at 1,000, a level it would not exceed until 1982. The Fed Funds rate was 5.66% in 1968 and rose to 16.39% in 1981. Returns on financial assets were poor during those 14 years. Gold and gold shares, on the other hand, turned in stellar performance.

The 1970's, for those of us who were around to enjoy them, do not conjure up happy associations when it comes to investing. The decade began with the demise of investment managers who had posted the gaudiest returns in the late 1960's, the "three Freds," Mates, Carr and Alger. The bond market was sound asleep, as detailed by Grant's "Where We Came In" (4/23/04). By the end of 1970's, bonds had been dubbed "certificates of confiscation" and being bullish on America was hazardous to one's financial health. The idea that stocks could provide positive investment returns was radical and socially risqué at the proverbial cocktail party. The decade-long process of undermining public confidence in financial assets was never obvious except in hindsight. It was not a blinding flash of awareness that minimized investment expectations. Instead, the investment equivalent of Chinese water torture, a repetition of bad experience sufficient for mass extrapolation, caused investors to demand single-digit equity multiples and double-digit coupons for 30 year treasuries.

The entrenchment of mistrust depends on deception, both externally applied and self-induced. In due course, history will reveal multiple deceptions at the core of the current bear market. In the 1970's, a short list would include the Watergate scandal, failure to communicate the war-time realities of Viet Nam, and "Guns and Butter" fiscal policies. For the financial markets, the disparity between nominal and real interest rates was central. During the decade, sky-high Fed Funds did not provide a positive yield due to an even higher rate of inflation. Real interest rates stayed in solidly negative territory from 1973 through 1981.

A core deception of the moment is the notion that a few up ticks of 25 to 50 basis points in short term rates will be sufficient to arrest the forces of inflation set in motion by the most aggressively accommodative Federal Reserve in history. Real interest rates, defined as the 90 day T-bill discount rate less trailing twelve months inflation, are negative by approximately 100 basis points (see chart below). This is, no doubt, a very gold-friendly statistic. A few hundred basis points of rate increases over the next twelve to eighteen months raises the possibility that this measure will no longer be so friendly. On the other hand, if measured inflation rises in lock step with the rate increases, the environment will remain positive for gold.

To predict real interest rates 18 months hence would require insight unavailable to most mortals and certainly to this writer. There are two components to the equation. Variable A is the future trailing twelve-month rate of inflation. The CPI "run rate" is 6%. Future CPI releases will be closely watched to see if inflation maintains the torrid pace suggested by recent data. Variable B lacks the apparent exactitude of the first. It is the measure of aggressiveness yet to be employed by the Federal Reserve Board in countering the incipient inflationary threat. Will it be ruthlessly Volcker-like, administering interest rate medicine so strong that the economy grinds to a halt, or will it continue to be Greenspan-like in staying behind the curve in order to not to shatter the eggshell pyramid of debt grounded upon the Fed's easy stance? While we have our own ideas on this matter, the behavior of the gold price in future months will provide the necessary illumination.

This analytical exercise is complicated by the fact that the CPI, a statistic revered by CNBC, brokerage house economists, and most of the investment community emits a signal that is profoundly less clear than its 1970's antecedent. Hedonic adjustments are applied to 50% of the item prices measured in the index. Hedonics is the science of adjusting product prices for qualitative improvements enabled by technology. Nearly all of these adjustments result in lower rather than higher price measurements. (For more, see The Real Value of the Dollar) The current version of the CPI also incorporates "Owners Equivalent Rent," which standardizes all housing costs on the notional rent that a homeowner would pay for similar housing quarters. Although the Office of Federal Housing Enterprise Oversight measures the 2003 increase in housing prices at 7.97% (and the 4^th quarter at 14.67% annualized), the Bureau of Labor Statistics figures that the housing component of the CPI has been advancing at only 2%, thanks in large part to the adjustment for Owners Equivalent Rent. Readings from the tricked up CPI of 2004 amount to little more than radar-confusing chaff. Other key indicators guiding economic policy may be similarly flawed.

Will the financial market add the missing 200-300 basis points back to the CPI in calculating the real interest rate? Our guess is that it will not. Understatement of inflation by the CPI will ultimately disenchant investment expectations. An inaccurate read on inflation will justify prolonged monetary ease. A continuation or widening of the present disparity between nominal and real interest rates is an important premise for a commitment to gold.

Finally, what collateral damage would arise from a multi-year rise in interest rates sufficient to quell gathering inflation? The policy choice will come down to whether it is preferable for the US consumer to pay for $3.50/lb. copper or 10% mortgage rates. Which is more visible and which is easier to hide? Since the days of Volcker and Reagan, the sensitivity of the US economy has shifted dramatically away from the price of copper and other raw materials and towards the price of money. The Fed has said as much in numerous speeches. With the interest rate on 56% of sub-prime mortgage loans calculated the adjustable way, unprecedented carry trade leverage, and the stock market "wealth effect" a beacon of policy, a political Fed seems likely to opt in favor of glossing over substantive issues versus Volcker-style tough love.

The gabby Greenspan Fed has failed to communicate to those offside in junk bonds, overpriced equities, interest rate swaps, emerging market sovereign debt, and all other unfathomable reaches of the carry trade of the stark choice between tolerating a further buildup in inflation or aggressive rate increases that would choke the economy and collapse the carry trade. To preempt inflation fostered by four years of aggressive ease, the Fed must drive a sustained and politically untenable rise in real interest rates. Rate increases cannot be tepid or token. Once inflation becomes entrenched in the industrial economy, financial structure, and public expectations, it is notoriously difficult to root out. The longer the Fed waits, the more severe the market pain. The Fed's policy dilemma contains the seeds of a prolonged bear market in financial assets. The unwillingness of political leadership to address the fiscal issues surrounding the open-ended financial aspects of terrorism in conjunction with generous entitlement programs is a recipe for expanding debt issuance, which the Fed will be called upon to accommodate. The Fed may continue to bark but it cannot bite.

Anyone who thinks that the recent slaughter of speculative longs in the gold market is an isolated event may wish to revisit their conclusion. It was a mini version of the Asian Meltdown, the '87 crash, LTCM, and the dot-com bust. It was one more misadventure of hot money. The mere inkling that interest rates might rise was a lethal pinprick to the hard asset investment bubble, which had co-opted gold. The prospect of higher rates also helped to strengthen the dollar versus the euro, adding further impetus to gold's sell off. The debacle was the work of an imaginary rate increase on a tiny sliver of the capital markets. Damage to a far broader range of financial assets will occur when the inexorable rise in rates actually begins. In such a context, gold's ability to protect capital will become widely appreciated.

Fear of collateral damage to financial assets has weighed on Fed thinking for several years. In the September 29^th, 1998 Federal Reserve Open Market Committee (FOMC) transcript, in the wake of the LTCM meltdown, Greenspan proposed a 25 basis point cut in the Fed Funds rate. He reasoned:

"I believe that the stock market decline has had a very profound effect, and indeed one can argue that a goodly part of the increased risk aversion is itself a consequence of the collapse in stock market values&so, in one sense differentiating equity markets and the credit markets is not something that is very meaningful because both very much reflect the same underlying process of pulling back&.the approximately $3 trillion capital loss in the aggregate value of equities in the United States, most of which are held by U.S. residents, just cannot be occurring without considerable breakage of crockery somewhere."

Greenspan correctly observed that there is a seamless linkage between credit and the stock market. He goes on to say that this represents a fundamental change from 30 years ago because "the aggregate size of stock holdings relative to income is so much higher now and so many more people have equity investments that the effects of stock market declines on economic choices is almost surely higher." A protracted decline in the equity markets, in the mind of Fed (and correctly so) would be a credit contraction by any other name.

Gold is without question a seasonal investment. Decades can slip by while gold slumbers, or worse. However, during extended credit contractions, when lenders and investors alike shy away from risk, credit spreads widen and safety becomes paramount. In the rainy seasons of the 1930's and the 1970's, gold rose against financial assets. It did so not because it was part of some "reflation cocktail" dreamed up and packaged by promotional investors. It did so because a general movement towards safety caused by adverse experience in financial assets investments bid up its price.

While monetary and fiscal policy can be temporarily marshaled to counter a market-initiated credit contraction, as has been done with some success since 2000, such intervention can only delay market forces. Worse, the cost of overriding such forces only increases the potential damage from a contraction. For example, does anyone think that the safety of leveraged closed end funds peddled to satiate the public's appetite for yield in a 1% interest rate environment is more than illusory? The narrowing of credit spreads since the Enron blowup (see above chart) reflects not a more sanguine assessment of general credit conditions but rather the success of the investment community in promoting junk to the satisfy the desperate scramble for yield. According to David Hale (4/19/04):

"During the last twelve months the total return on emerging market C rated debt has been 34.5% compared to 6% on A rated securities&The share of triple C borrowers in the U.S. high yield market rose to 23% during the past few months, or the highest level ever recorded."

The reflation trade has been a truly reckless game. It depended on the inconsistent rationale of 1% money, Fed largesse forever, and the prospect of synchronized non-inflationary global growth. Now that inflation is knocking on the door, the Fed has been forced to blow the whistle. However, it cannot go beyond issuing warnings without sabotaging investors and borrowers alike who cannot tolerate the portfolio markdowns or cost increases that a restrictive stance would imply.

Richard Russell, veteran market analyst, harbors no doubt that we are in the early days of a protracted bear market: "First, what's happening--and I'm not talking about markets, I'm talking about fundamentals. I've been talking about the monster edifice of debts in the US--debts in the cities, the counties, the states, the corporations--consumer debt, mortgage debt, credit card debt, you name it, anywhere you look all you see is debt. The nation is up to its eyeballs in debt" (Dow Theory Letter 4/19/04). Under these circumstances, Russell observes, rising interest rates are deflationary. The potential destruction to financial asset values from rising rates is unprecedented.

To time the tipping point between inflation and deflation, as with calling the top for the dot com mania, seems futile. What is clear, however, is that the fear of deflationary outcomes begets inflationary policy responses, as Fed Governor Bernanke has so forcefully stated over the last few years. While there can be no doubt that the end game is deflationary, an inflationary episode or two may occur along the way. For gold, it makes little difference because either prospect erodes confidence in financial assets.

"Investors continue to buy into the notion that this or that government official can pull a few levers and make things right again," says David Lewis, a former New York FX options trader. There is an unstated assumption that economic outcomes can be achieved through adherence information known only to a small circle of practitioners. The proper examination of arcane data somehow yields clues as to whether or not to raise interest rates. The totality of capacity utilization rates, unemployment claims, PPI, CPI, the Taylor rule, productivity and countless other "objective" data points comprise the compass for economic policy. In his excellent study of financial market risk "Fooled by Randomness," Nassim Nicholas Taleb remarks: "Psuedo science came with a collection of idealistic nerds who tried to create a tailor-made society, the epitome of which is the central planner."

As for the Financial Times' observation that gold is a risky investment because it offers little or no return, we agree in part. However, the risk in gold is not the inherent lack of return. The risk is whether holding a position is timely or not. There is little to analyze about gold itself. It is what it is--inert, mute, and passive. Unlike stocks or bonds, there is no internal compounding or coupon. However, there is much to analyze about whether investors will eventually find gold to be attractive or otherwise.

We were cheered by the recent FT disparagement of gold. It reminded us of an FT opus entitled "The Death of Gold" published December 13^th, 1997, approximately 18 months before the bull market in gold commenced. Then, as now, the FT point of view was heavily influenced by official sector actions: "And, two weeks ago, Argentina revealed that it had sold its entire gold reserves in the first half of the year, all 124 tonnes, and invested the proceeds of $1.46 billion in US treasury bonds." Our math says that Argentina received approximately $342/ounce or 13% less than the current market, to invest in a depreciating asset. We were cheered also by the cover story in Barron's (5/3/04) titled "Bear Overboard: The Big Money Poll bulls outnumber bears by a wide margin, despite the market's recent woes." As contrarian investors, we are thankful for the continual feast of ignorance served up by the financial media. The day that the Financial Times, Barron's, or the equivalent begin to advocate gold will rank among the classic sell signals of all time.

John Hathaway
© Tocqueville Asset Management L.P.

This commentary is not an advertisement or solicitation to subscribe to The Tocqueville Gold Fund, which may only be made by prospectus.

The Gold Fund is subject to the special risks associated with investing in gold and other precious metals, including: the price of gold/precious metals may be subject to wide fluctuation; the market for gold /precious metals is relatively limited; the sources of gold/precious metals are concentrated in countries that have the potential for instability; and the market for gold/precious metals is unregulated. In addition, there are special risks associated with investing in foreign securities, including: the value of foreign currencies may decline relative to the US dollar; a foreign government may expropriate the Fund's assets; and political, social or economic instability in a foreign county in which the Fund invests may cause the value of the Fund's investments to decline.

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