REASONS TO KEEP GOING FOR GOLD / BARRON´S

Wednesday, September 9, 2009

INVESTORS' SOAPBOX AM

Reasons to Keep Going for Gold

MKM sees a recovery in monetary velocity.

MKM Partners

THE PRICE OF GOLD has pushed above $1,000 per ounce for the first time since March 2008. Not surprisingly, the dollar is slipping against G6 currencies, essentially giving up all of its post-Lehman gains.

The low point for gold this year was on Jan. 14 when it closed at $811.70 per ounce on a cash basis. Since that time, bond-market inflation expectations have also pushed higher, with the 20-year inflation breakeven-spread rising to 206 basis points from 97 basis points.

The yield-curve slope (30-year/two-year) has widened over this period and now stands at 337 basis points from 218 basis points in mid-January. Although some are attributing the rise in gold to a resumption of credit-market fears, this is contradicted by market action during the intervening period.

Indeed, since gold bottomed in mid-January, credit-market stresses have eased with the TED spread (three-month London Interbank Offered Rate (Libor) to the three-month T-bill) falling to 18 basis points from 99 basis points and long-term funding spreads (Moody's Baa to Treasury) falling to 289 basis points from 572. High-yield spreads have dropped to 859 basis points from 1,581 basis points during the same period. So the message from market-based indicators is that inflation expectations have been drifting higher while credit-market stress has been easing.

Intuitively this makes sense because deflation increases the strain on debtors while inflation eases it.

The behavior of market-based indicators is consistent with a recovery in monetary velocity. To restate: since mid-January, the price of gold has risen, the slope of the yield curve has widened, bond-market inflation expectations have pushed higher, the credit markets have rallied and the fed-funds rate has been parked below long-term inflation expectations. The behavior of these market-based indicators is consistent with a recovery in monetary velocity, which crashed last year on the back of the largest credit-market shock since the early 1930s.

Interestingly, the growth rate of broad liquidity has slowed markedly during the last six months. Both MZM (money zero maturity) and M2 have slowed sharply during the last few months, with 13-week annualized growth rates for these broad aggregates slipping to negative-3.5% and negative-4.3% annualized returns, respectfully. With total bank-lending (loans and leases) also in negative territory, a purely monetarist interpretation may call for caution on the outlook from here.

But we believe there is more nuance to these statistics than can be gleaned from a literal interpretation. First, the slowdown in the broad aggregates has been driven by decided weakness in money funds, which inflated on the back of the stock-market crash of 2008-2009. Money-market cash (relative to equity-market capitalization) still stands just over three standard deviations above historical mean. So there is certainly no shortage of cash in the system. Loan growth tends to follow economic recoveries, not lead them. Thus, what we could be witnessing here is a shift in the velocity of broad liquidity, which would be consistent with the action in gold, the dollar, the yield curve and the credit markets. A similar broad money slowdown occurred in 2003, also with negative-real-short rates and a vertical-yield curve.

(An inverted-Treasury-yield curve accompanied by negative growth in the inflation-adjusted money supply tends to precede business cycle peaks and recessions. This condition does not exist at this time.)

That weakness proved temporary, and did not precipitate a stock-market correction, sell-off or bear market. We would also be remiss if we did not point out that the Fed's balance sheet has begun to grow again as purchases of agency mortgage-backed securities and Treasuries have begun to offset the drain from other emergency programs rolling off. If we subtract excess reserves from the high-powered money stock (leaving currency plus vault cash plus required reserves), the monetary base has been growing steadily at a double-digit pace. Not hyperinflationary territory by any stretch, but not consistent with monetary stringency, either.

The increase in the price of gold since mid-January has been associated with a wider-yield curve, a push higher in bond-market inflation expectations, and a sharp narrowing in credit-market spreads. Intuitively this makes sense because deflation increases the strain on debtors while inflation eases it. At the same time, however, the growth rate of the broad money stock has slowed sharply.

What's going on? The behavior of these indicators is consistent with a recovery in monetary velocity, which crashed last year on the back of the largest credit-market shock since the early 1930s. We believe the weakness in broad money growth is probably temporary and benign, as it was in 2003 when the yield curve was vertical and short rates were parked below long-term inflation expectations.

We initiated a "buy" call on gold on Dec. 29, 2008, and remain bullish on the yellow metal as we are on other reflation-oriented equity sectors and themes.

--Michael T. Darda

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