Gold Market Update

The 50 basis point cut by the FOMC last Wednesday morning in its target for the federal funds rate took short-term nominal U. S. interest rates below German rates for the first time since 1994. Because the U. S. has higher inflation than the Euro-Zone, euro real short-term interest rates became even higher than real U. S. rates. This may be a reason for the dollar faltering against other major currencies since last Tuesday.

A weakening dollar may put the Fed on the horns of a dilemma. The U. S. dependence on foreign private capital to fund its current account deficit may limit the Fed's ability to cut interest rates further without risking a collapse of the dollar. If foreign private investors pull their capital out of U. S. markets, dollar instability may again cause them to seek the protection of gold.

Gold strengthened under the dollar's weakness, ending last Friday at $ 264.80 an ounce, up 1.8 % from $ 260. an ounce two weeks previously. The Philadelphia Gold/Silver Stock Index (XAU) rose 3.2% during the same period.

Real 12-month Treasury Note yields have already come down from approximately 5% in 1994 to approximately 0.5 % last Friday. Real Treasury Bill yields are even less. If current low short-term interest rates do not succeed in stimulating the economy because the imbalances of the 1991-2001 credit expansion have not been corrected, the Fed may lower short-term rates again. This may result in real short-term interest rates becoming negative, as they did in the 1970s when gold soared from $ 35 an ounce to $ 850 an ounce and in 1993 when gold climbed from $ 327 an ounce to $ 410 an ounce. When real interest rates become negative, creditors are faced with a gradual impoverishment and effective confiscation of their wealth in real terms. They then may seek to preserve their wealth by turning to tangible assets instead of financial assets. Gold again becomes a real "store of future value" in this environment.

Japan's example may be instructive. After Japan's boom burst in 1990 the Bank of Japan aggressively eased money to a degree unprecedented in the history of central banking in the world in terms of both interest rates and volume. Short-term interest rates were reduced to almost zero. Since over 50% of aggregate personal sector financial assets are held in the form of cash and deposits, households suffered a substantial blow to their purchasing power. Aggregate demand weakened, and savings rose. At the same time low interest rates failed to encourage business borrowing, and bank loans decreased at an annual rate of 1.4% during the past five years. In addition, the government had over 10 deficit stimulus packages to attempt to forestall a major recession and to lift the economy out of its post-bull market slow-down. Its ratio of gross debt to GDP soared from less than 60% in 1990 to 130% currently. It is now heading toward 150 %, the highest debt ratio of any industrial country. These policies have failed to cure its excess bad debts, excess unemployment and excess capacity. In desperation, the Bank of Japan took an experimental step in March in the direction of "quantitative easing", the purchase of long-term government bonds in excess of the trend growth of currency in circulation to target bank reserves in addition to interest rates toward a rate of inflation greater than zero. This may well damage confidence in the credibility of monetary and fiscal discipline, and in turn raise long-term interest rates. Ten year government yields have already climbed from 1.057 % in March to 1.43 % last Friday. Japan's Nikkei 225 index ended down 27% last year and in March fell to its lowest level since 1985. The yen has declined 12.7 % against the dollar from its November high to April 20th. Correspondingly, the yen price of gold has climbed 14.6 % during this period. Japanese investors in gold have more than preserved their wealth. If confidence in Japan's economy and currency continues to erode, Japan's investment demand for gold portfolio diversification could grow substantially.