The gold price plummeted $19.43 to $1,092.57 and gold mining stocks followed as continued strength in the U.S. dollar sent the prices of gold-related investments lower. The U.S. dollar has appreciated as short dollar trades are unwound in anticipation of brighter growth prospects for corporate America and an eventual end to the crisis-driven monetary policy of the Federal Reserve. This has been apparent in the price action in the bond market as the 10-year yield reached 3.69%, its highest level in four months.
Bond yields are rising as growth expectations increase as the economy recovers from the severe recession. Moreover, the 2-year/10-year yield curve, at 282 basis points, is trading at its steepest level ever. The steepening yield curve is positive for the banking industry as they can borrow short and lend long, leading to enhanced profit margins. The steep yield curve demonstrates rising inflation expectations, a fact that is pressuring the gold price due to the potential policy response that could be necessary to combat inflation.
The widening spread between the yield on the 10-year and the yield on the 10-year Treasury Inflation Protected Securities (TIPS) is another sign of rising inflation expectations among investors and traders. If these expectations continue to rise and become “unanchored,” a term often used by the Federal Reserve, then the response from the central banks will be toward tighter monetary policy, which is bullish for the U.S. dollar and bearish for the gold price. The recent strength in the U.S. Dollar and weakness in gold is partially due to the anticipation of a more hawkish Federal Reserve.
The current correction in the gold price and gold mining stocks has sparked debate over the next direction of the sector amongst a wide spectrum of market pundits and investors. Doug Kass, the general partner of Seabreeze Partners and contributor to RealMoney on TheStreet.com, made a bold prediction for gold in his annual piece in which he predicts upcoming events in the financial markets, economy, and social and political arenas. In 20 Surprises for 2010, Mr. Kass, who accurately called the March 2009 bottom in the equity markets, forecasts that the price of gold will plunge next year. Kass predicts that, “Gold’s price plummets to $900 an ounce by the beginning of second quarter 2010. Unhedged, publicly held gold companies report large losses, and the gold sector lies at the bottom of all major sector performers. Hedge fund manager John Paulson abandons his plan to bring a new dedicated gold hedge fund to market.”
Kass references the launch by Mr. Paulson, one of the most successful hedge fund managers of all time, of a gold fund starting January 1, 2010. In order to invest more of his personal wealth in what he believes is one of the best investment opportunities going forward, Mr. Paulson has hired two prominent gold analysts to join his team and will invest $250 million of his own funds in the vehicle. Accordingly, Mr. Kass’ call for Paulson to abandon his gold fund is considerably more shocking than his bearish view on the gold price. Coincident with his bearish view towards the gold sector, Kass predicts that the U.S. dollar “explodes higher” and will be the “strongest major world currency during the first three or four months of the New Year.”
Another well-known investor and market pundit, Dennis Gartman of the Gartman Letter, has espoused a similar view with respect to the U.S. dollar - while at the same time holding a divergent outlook for gold. Gartman wrote to his subscribers on December 9, with the U.S. Dollar Index (DXY) approximately 2.5% below its current level, that the dollar had “undergone a WATERSHED shift in its trend” and has reiterated that the greenback has altered course from “a relentlessly bearish move to one that is only now becoming understood as a bullish trend change.” At the same time, Gartman, in order to express his bullish views on the gold price, has positioned his fund to be long gold in terms of the euro, pound, and yen - in order to avoid being exposed on the short side to the U.S. dollar.
In contrast to Gartman’s bullish outlook for gold, the managers of Woodbine Capital, a global macro hedge fund founded in January 2009 by Josh Berkowitz and Marcel Kasumovich, recently laid out the case for why gold is an unattractive investment. The two former executives at Soros Fund Management, the hedge fund run by legendary investor George Soros, penned in their October 2009 investor letter a section entitled, “Gold - The Anti-Goldilocks.” Woodbine began its essay by stating that gold bugs frequently argue that gold protects against the hyperinflationary consequences of excessive money printing and currency debasement by the Federal Reserve, as well as against the risks of a deflationary credit collapse in which central banks lose credibility and market participants lose faith in the entire financial system. They argue that the fundamental catalyst for a higher gold price is more likely related to stronger demand from emerging markets, due to higher income growth and stronger local exchange rates. As such, given the strong performance of gold over the past decade, Woodbine argues that going forward there “are probably more powerful and cheaper ways of representing that theme.”
Woodbine goes on to assess if gold could be the next asset bubble, and provides a list of key factors inherent in any bubble and how they relate to gold in this particular instance. These factors include a rational theory for owning the asset, “one-sided exuberance“ - such as the aforementioned gold bugs argument that gold performs well in any type of market climate - and the fact that market prices imply very little probability of downside risk.
The managers examine the supply-demand dynamics in the gold market and conclude that the relationships between these factors suggest a fair value gold price of $820 per ounce. Berkowitz and Kasumovich also discuss their view that investment demand for gold is driven in part by circular logic, similar to that of housing bulls earlier this decade - which involves higher investment demand leading to higher gold prices, higher prices signaling the benefits of diversifying through gold, which consequently leads to even higher investment demand.
Finally, the firm proffers a contrary view to those who believe that the gold price will continue to rise due to the fact that it provides a hedge to ever-increasing government liabilities and the inflationary side effects of easy monetary policies. Woodbine argues that the deflationary risks of private sector deleveraging, high unemployment, and falling real estate prices provide strong opposition to the inflationary effects of loose monetary and fiscal policies by policymakers.
A small and quiet minority just a few short weeks ago, dollar bulls and gold bears have emerged front and center following the rally in the dollar and the steep decline in the gold price. At the end of the day, the beginning of new secular trend of a higher dollar and lower gold prices requires a robust outlook for the U.S. and global economy. It requires the belief that the multi-decade expansion in credit and leverage has been successfully unwound in a short 18 month time frame with the stage now set for sustainable economic growth. Wall Street has a very short memory - and the consequences of this fact are likely to be apparent in future quarters.
