Gold on a Roll

Now it has rallied to approaching $US500 an ounce, the gold price is likely to go higher. In late November it reached our multi-year price target of $484 and is now swinging higher than that level.

“Currency markets always overshoot.” That was actually a formal statement by economist Rudiger Dornbusch, who wrote it in a journal article in the 1970s. Dornbusch constructed a little set of logic as to why that happened. Still, I think one of the better sets of logic as to why currencies overshoot was contained in an article that I recently reviewed, by Robert Aliber of the University of Chicago.

Institutions are constantly following currency trends '” not just hedge funds but large banks. Those trend-following institutions tend to back currencies continually as long as momentum is favourable. A number of people have asked me, 'Given that the $US has been so strong, why is it that the gold price has gone up?’ Our argument is that the $US gold price is responding to the increase in the US budget deficits over the past four years.

It is interesting to note that gold is the only currency that can’t run a budget deficit. Budget deficits have been increasing everywhere else. The budget deficit has increased for the whole Euro area to 3% of GDP. In the major Euro countries, deficits are much larger.

The International Monetary Fund tells us for this year Germany would run a deficit of 3.9% of GDP. France will run a deficit of 3.5% of GDP, and Italy will run an even larger budget deficit, of 4.3% of GDP. So it is rational at this stage for gold to be rising in all currency terms.

How far can it overshoot? Well our model tells us that it has a 15% probability of overshooting as far as $US527 an ounce, and it has a 5% probability of overshooting as far as $550 an ounce. However, investors will note that those probabilities can be achieved every weekend at the racetrack. Should they want to invest in things that are going to give a high probability of return, they might consider moving their investment from gold at these heady levels to other things.

One of the areas that will give competition to the gold price over coming quarters is the increase in the attractiveness of substitutes. One of those major substitutes is the Euro. We have seen the Euro being sold down to undervalued levels. Our model of the Euro tells us that fair value of the Euro should be trading at about $US1.27, which is 8.5% higher than current levels.
One of the reasons the Euro has been oversold is because of the inactivity of the European Central Bank. At ABN-Amro Morgans we actually publish a model of European Central Bank behaviour. In that model we include the “Euroland” budget deficit, which we have just said has significantly increased. We include harmonised Euroland inflation, which is currently about 2.5%. This is not much, but it is higher than it was a year ago. We also include Euroland inflationary expectations. What that model says is the European Central Bank short rate equilibrium level at the moment is 2.75%. The current European Central Bank (ECB) short rate is 2%. We anticipate that the ECB short rate will rise by 75 basis points over the next couple of quarters. That will make the Euro more attractive, and the Euro will rise towards $1.27.

Returning to my comments on gold: gold is fair value. All currencies overshoot and you can bet on gold going higher. As I say, odds on such a bet are just as good as those available at the racetrack every weekend.