Why Gold Is Headed Much Higher

What really drives the price of gold? Some say it's a fear gauge. Others prefer to look at the demand coming from the Indian wedding season. But the silliest of all conclusions to reach is that the dollar price of gold should be determined solely by its value vis-à-vis another fiat currency.

The truth is the primary driver of gold is the intrinsic value of the dollar itself, not its value on the Dollar Index (DXY). The intrinsic value of the dollar can be determined by the level of real interest rates. Real interest rates are calculated by subtracting the rate of inflation from a country’s "risk free" sovereign yield. Right now the level of real interest rates in the U.S. is a negative 1.55%.

A key factor is to then determine the future direction of real interest rates. The more positive real rates become, the less incentivized investors are to hold gold. And the opposite is also true. The more negative real rates become, the more necessary it is to own an asset that is proven to keep pace with inflation. The Fed has threatened to begin lift off from its zero interest rate policy in the middle of next year. However, the Fed has made it clear that it will only raise nominal yields if inflation is rising as well. Therefore, there is no reason to believe real interest rates will rise anytime in the near future.

The intrinsic value of the dollar is not rising; and most likely will not increase for the foreseeable future. The dollar is only rising against other currencies because the value of those currencies are being pummeled by their central banks to a greater extent than our Fed.  The weightings in the DXY favor the performance of the dollar against the euro and the yen. Therefore, just because the nations of Europe and Japan are determined to completely wreck their currencies does not mean that the intrinsic value of the dollar is improving or that the dollar price of gold must go down. In fact, holders of the euro and yen should be more compelled to own gold than ever before.

The sophomoric view held on Wall Street is that gold must go down if the dollar is rising on the Dollar Index. Their specious argument is that it's more expensive to buy gold because of the dollar's strength, and therefore demand for the commodity must decrease. However, this argument completely overlooks the increased motivation to buy gold emanating from the continued attack on the yen's intrinsic value by the bank of Japan. For example, real interest rates in Japan are a negative 3% and are promised by the Bank of Japan to keep falling. Japanese citizens should be scrambling to own gold in this scenario even if it will take more yen to buy an ounce of gold. And from all evidence available demand for the physical metal remains strong.

Supply demand metrics for gold are currently favorable. Central bank demand increased to 335 tons so far this year, up from 324 tons in 2013. Investment demand is up 6% YOY, while supply was down 7% YOY in Q3. Nevertheless, gold is down about $100 an ounce YOY, and gold mining shares have plummeted by about 30% during the same time period. This is due to short selling of gold futures by banks that wish to see the gold price lower. In the short-term financial institutions may be able to manipulate gold prices lower, as they bring to fruition their self-fulfilling prophesies.

However, in the long run there exists three great risks to markets and the global economy in general that will be very supportive for gold: A collapse of the yen that becomes intractable; spiking interest rates in the United States due to the Fed’s unwillingness to get ahead of the inflation curve; or, more likely, a significant weakening in U.S. economic data that puts serious doubt in the sustainability of the recovery and corporate earnings growth.

At least one of these events is guaranteed to occur because the free market price discovery mechanism has become completely abrogated and has been replaced by government manipulation of all asset prices.    When these massive bubbles break it won’t be so easy to put them back together again because central banks and sovereign balance sheets are already at a breaking point. Therefore, the recovery won’t be as easy to engineer like it was back in 2009.

Equity prices have been propelled to record highs by the money-printing frenzy of central banks. And the Fed Funds Rate is near zero percent, instead of a more normal 5%. The total debt in the United States is near an all-time record 320% of GDP. U.S debt is up $7 trillion (14%) and global debt has increased over $30 trillion (40%) since 2008. Most importantly, the record amount of debt has been coupled with interest rates that have been artificially manipulated to record lows around the world for the past six years and counting.

This is why I know it will all end very badly once interest rates normalize. Regardless of bank manipulations and the BOJ’s kamikaze mission to commit Hara-kiri with its currency, gold will be an increasingly-necessary asset to own. Especially after this current illusion of prosperity comes crashing down.

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You can learn more about the coming economic chaos by getting a free trial subscription to my Mid-week Reality Check podcast located at www.pentoport.com.

Michael Pento is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”