Gold, Interest Rates and Commodities

The purpose of this report is to correlate the inter-relationship between Gold, Interest Rates and Commodities.

As gold and other precious metals play a special role in our society, it is interesting to evaluate their influence on financial indicators and future economic trends in our society. One of the best ways to visualize the inter-relationship of these factors is via charts.

As gold and precious metals strongly touch our emotions and influence our behaviour in money affairs, there are some meaningful correlations between interest rates, the stock market and the economy. These correlations reveal the ground rules for an investing strategy in natural resource stocks, which could well produce a climactic reversal, outperforming the current market due to a dramatically changed economic environment.

Historically, the gold price is a leading indicator as it tends to predict interest rates. When the gold price is high, interest rates tend to rise in the near future.

Gold as a leading indicator to interest rates is more obvious when gold price changes are plotted. Except for the last upswing in interest rates in 1999, the gold price trend led interest rate levels by about a year. In 1986, 1993, 1995 the gold price accurately forecasted higher interest rates. In 1985, 1991,1994 and 1997 gold predicted lower interest rates.

Gold as an accurate forecaster of interest rates failed only 1998, which gives credence to the accusation that the gold price in the recent past has been subject to PRICE MANIPULATION.

The gold price is also a good leading indicator for the CRB Future index. When the gold price rises, raw materials rise as well. The higher price for raw materials generates inflation, which translates into higher of borrowing (i.e. interest rates). Consequently, rising interest rates reduces the money supply - and thus diminishes credit expansion.

The real money supply growth is strongly dependent on raw material prices. Rising raw material prices diminished real money growth in past decades, as higher raw material prices fostered inflation. This was the case in1974, 1981, 1989 and1994. It is interesting to see that raw materials prices rose less and less over the last 30 years, while monetary growth accelerated. This is the most likely reason for the current stock market boom, which was made possible through unprecedentedly high money supply growth.

The charts suggest the supply of raw materials grew larger in recent years. This is surprising, because researchers predicted 30 years ago that there would be an enormous shortage of raw materials for the year 2000 and beyond.

One of the reasons why raw materials are cheaper today is our ability to produce them faster through higher economies of scale.

Although most raw materials are at historically low value, it is imperative to realize water, soil and oil are suffering grievous depletion rates. According to the World Resource Institute, two billion acres of agricultural land has been degraded in the last fifty years. Each year an additional 12 to 25 million acres of agricultural land is lost through over- extensive soil treatment.

Moreover, US and Canadian oil depletion rate during the last two years is alarming. Oil expert, Colin Campbell (The Coming Oil Crisis), forecasts an oil shortage in the not too distant future. The United Kingdom is even worst off. The UK's oil reserves of the will only last another five years.

The cardinal factor driving commodity prices lower is that production facility capacity is outpacing demand growth. That is to say productivity is greater than demand. We can pump oil much faster through huge oil rigs, harvest agriculture several times per year and produce paper in fully automated mills.

The above scenario created the allusion of huge reserves. HOWEVER, it is just the production capacity rate that is very high, not the resource reserves themselves. This economic paradox substantially reduced the price of raw materials in recent decades, leading to lower inflation, and fostering lower interest rates and higher productivity.

Nevertheless, an end to the trend towards ever increasing economies of scale and falling raw material prices is foreseen. The reason is simple and logical. Some natural resources are becoming really scarce. Palladium is one example for this trend. For years the market place has been anticipating great palladium supply from Russia - the world's largest producer of this precious metal. However, Russia is virtually bankrupt, and would therefore sell any palladium inventory it had to increase its foreign capital reserves. But alas, Russia does not have extra palladium to sell. Even if the Russian had been astute enough to have kept a palladium inventory in reserve, the Russian mafia would have had it already monetized -- and have put the money into a dollar account.

The Russian 'store-room' is already empty. As palladium is just a harbinger for the precious metals trend, my recommendation is to invest aggressively in palladium stocks -- such as North American Palladium, which already appreciated fivefold during the last months. In my opinion this palladium play is still vastly undervalued - and therefore is one of my top picks. Ironically this stock was recently delisted from the NASDAQ exchange. However, it does trade in Toronto.

Precious Metals Prognosis

It is my opinion palladium will lead precious metals in the coming bull market.

For reasons already stated above, I believe we will see a sudden price spike in raw materials. Gold as the traditional harbinger for such a bull trend is unfortunately tainted as an inflation indicator. This is most probably due to overt price manipulation by Central Banks. Consequently, gold will probably flip-flop, becoming a lagging indicator. Nevertheless. History is testament to the fact that government interventions are rarely successful. Therefore, gold will rise again…faster and farther than in previous bull markets.

The economic consequences of the scarcity of resources are the fact that variable costs will outpace fixed costs in the goods producing industry. That means the dinosaurs have become so big that it becomes now more and more expensive to feed them -- and to distribute their products. As fixed costs are already lower than variable costs for many products, the increasing price for raw materials will trigger an upward spiral for many consumer products and services. This includes also the high tech and Internet economy through higher transportation costs of delivered products. This overall result will be a surprising spike of inflation over the next years, which implies also an increase of the gold price in line with incredible economic activity as a lot of cash will come out of the mattresses. So, in that sense gold will also become a barometer of higher worldwide economic activity and global wealth.

Fear about the value of the money will replace fear about the economy and personal situation - especially in the South East Asia and Japan the world's biggest money savers. Of course, banks will have a difficult time through higher interest rates, yet the worldwide economy will benefit as the huge worldwide money pile will finally flow out of the banks and stocks.

There are also political consequences for declining worldwide resource reserves. The last peace talks between Syria and Israel failed. One of the chief obstacles was the control of scarce water supply. The same water supply problem exists between Turkey and Iraq.

Conflicts will also arise over crude oil. The US has currently net oil and oil products imports of 10 million barrels per day - a record high. Oil production in the United States stands at the lowest rate in over 50 years. Although the US oil production and reserves position was independently good in recent years - vis-à-vis foreign producers - the fundamentals have changed considerably. This is not the case today. Today, the US is very dependent on foreign crude production -- as Asian demand for petroleum products explodes.

Indubitably, the political position of industrial countries versus developing nations is much weaker than it was five years ago. Additionally, the current account balances of developing nations have strengthened considerably in recent years through currency devaluation. Moreover, foreign reserves of developing and newly industrialized countries are at record highs of about 60% of total non-gold world reserves.

Finally, the increase of raw material prices will force our society to handle our natural resources much more carefully than we do now and find sustainable procedures to live in balance with nature.

I look forward to receiving your comments

Dr. Heinrich Leopold

14 January 2000

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