Gold Market Update

Following gold's $25 rise in less than five trading days a normal correction was abetted by rumor that Russia might sell gold to aid Siberian flood victims. A Thursday rally was turned into a decline that extended into Friday. A denial followed, but for the week gold declined $8.30 an ounce, less than half the preceding week's gain, to close at $279.l0 an ounce. Despite today's opening decline, rising open interest that occurred as gold declined is a bullish indication that short positions were added rather than that long positions were rapidly liquidated.

The Russian rumor fits the mold of a conspiracy theory suggesting that central banks and others collude to depress gold's price. We are not necessarily conspiracy adherents, but it is an open secret that central banks rarely favor a higher gold price. This was true even under the gold standard. In those days, however, the ability to convert paper money to gold was the discipline that prevented currency depreciation.

Then in the l960's the American-European gold pool overtly intervened in the market to hold gold at $35 an ounce. In the l970's the U.S. and the I.M.F overtly sold gold to suppress it's price. Gold soared as each attempt finally failed.

These were open activities. Should the collusion theory be documented in a pending legal case the esteem of central bankers and their paper notes would almost doubtless plunge.

Last week's employment, housing and durable goods reports indicated continued weakness in the U.S. economy. Europe's GDP growth continued to weaken, even as inflation rates rose. The European Central Bank's credibility has suffered and the euro languishes.

Economies may be slowing, but speculative boardroom activity has resumed. Multi billion dollar merger deals include A.I.G. and American General, Germany's Allianz and Dresdner Bank, Nestle and Ralston, and now Alcatel and Lucent. Then, on the very day that the Federal Reserve reported a tightening of bank lending standards Citigroup announced a $12.5 billion take-over of a Mexican bank. Perhaps most bizarre is the bidding between the impeccable duo Warren Buffett and General Electric for bankrupt Finova Group.

High investor confidence and corporate devotion to debt were exemplified by a twice over subscribed record $ll.9 billion note issue by World Com. It is this allegiance to debt that links gold's perceived value to recession. During the l998-99 bubble years corporate debt in the U.S. rose $900 billion, a 12.5% annual rate. Financial debt, the source of much speculation, rose $2 trillion, an l8% annual rate. This debt is not, as in the l970's, being rapidly inflated away, meaning a serious recession could inflict intense strain on the financial system.

Suggestions to the contrary notwithstanding, commercial banks remain a potent force in the U.S. credit system. Bank stand-by letters of credit and other contingent liabilities, for which no reserves are provided total $4.7 trillion. Combined with stated liabilities, actual and potential bank credit is at least 50% of total non-financial, non-federal debt outstanding.

In a speech last week, Chairman Greenspan noted the Federal Reserve raised interest rates steadily during the year beginning June 1999 but conceded that M2 continued to rise rapidly. What the Fed did not do was to offset external forces, including funds from abroad and highly leveraged derivative activity that inflated the U.S. credit market.

Now, contrary to previous periods of Fed easing, long term Treasury bond yields have risen dramatically. Chairman Greenspan fell into the supply-demand trap by attributing this anomaly to the expectation that fewer Treasuries will be retired than previously thought. How, then, does one explain how the great l981-86 bond bull market could have coincided with the largest volume of Treasury bond issuance in history? Perception of value is the answer.

Mr. Greenspan also said he expected consumer prices to be contained. Where then will the huge and rapidly growing M2, M3 an MZM to go? If not to inflation, perhaps to speculation or perhaps lie idle, as in Japan where banks have just refused free money from the Bank of Japan.

We believe that the consequences of any of these alternatives sound bullish for gold.