First of all, apologies for not writing this column many months ago. I haven't had much time to sit down and convey my thoughts on this matter. Most of the money being short gold has probably been made, but I'd like at least to do my best to hypothesize why gold has slipped into a major bear market even while the Fed and other central banks around the world have been "printing money" with their QEs, Abenomics and the rest. Gold has slipped into a bear market because the improving economy and increasing private investment are pointing to an eventual normalization of real interest rates to a positive level away from a gold-friendly negative level.

Gold as a neutral currency

Over the long term, the way to look at gold is as the "neutral currency", i.e. a store of value against paper currency inflation and the price of things in general. In the short run, however, gold is as prone to speculation as any asset and tends to go through long bull and bear markets depending on traders' views of monetary policy and the structural state of the economy.

Why does gold serve as a store of value more than other commodities? Because it doesn't get "used" in the same way that oil or corn get used, nearly every ounce ever mined is still in human possession either as jewlery or bullion. That means the gold supply is extremely stable, virtually unaffected by the amount that gets mined each year.

This quality is why gold has been used as a monetary asset throughout history. As an investment, however, gold doesn't pay interest, so it only serves as a long term store of value or as a short term vehicle for speculation.

In a normal environment, holding a dollar in the bank would pay enough interest to compensate you for the risk of holding that dollar. Because the FDIC guarantees cash bank deposits against default, the only risk of holding cash at a bank is that the interest rate may improperly compensate the holder for inflation.

Gold versus cash

All things being equal, if the interest rate on bank deposits is less than the rate of inflation, then the value of bank deposits are losing purchasing power and thus gold would serve as a better store of value than cash and the price of gold in dollars would rise. If the interest rate on cash is above the rate of inflation, then you would get a positive "real" return on cash and because gold pays no interest you would prefer cash and the price of gold in dollars would fall.

As a side note, if we assume a 2% inflation target and a 28% average tax rate on bank interest (or short term treasury securities), the "neutral" overnight interest rate would be 2.8%, generating an after-tax, after-inflation risk free return is 0%. So if there was no business cycle and/or the Federal Reserve Bank was perfect at executing policy, then all future maturities of US Treasury bonds would yield 2.8%, inflation would always be the Fed's 2% target and the rate on Treasury Inflation Protected Securities ("TIPS") of all maturities would be 0.8% (to compensate investors for taxes).

The forward market for real interest rates

Of course all things are never equal. The capital markets are always
trying to anticipate the future. When looking at the market for Treasury
securities, investors are making assumptions about how real interest
rates will average out in the future based on the Fed's reaction to the
business cycle and how it will effect inflation and the business cycle
itself. The business cycle is primarily driven by the changes in
psychology of the suppliers of cash (savers and banks) and the demanders
of cash (businesses, governments and real estate developers). The
treasury market represents the market's assumptions about the future of
the market for risk-free cash, while the rest of the securities markets
represent the market's assumptions about the performance of
non-risk-free investments relative to the market for cash.

Because the future is uncertain, a normal treasury curve has a rising, positive slope to reflect increasing amounts of uncertainty over time. The assumption I have always used for my market model is that the overnight level of real rates is 0.8% and that the 2-year TIPS yield would be 1%, the 5-year TIPS would be 1.3%, the 10-year would be 1.8% and the 30-year would be 2.3%.

During recessions, when the demand for cash by savers is high relative to longer term investments, the Fed engineers cash interests rates below the rate of inflation to entice savers to increase their demand for longer term securities.

When savers become more optimistic, the prices of long term securities improves and the Fed would then be able to normalize the level of short term rates to balance the demand for cash versus long term securities.

When savers become too optimistic about the business cycle, the excess demand for long term securities pushes the cost of capital too low, causing more marginal projects to get funded. If the Fed sees this happening, it raises the short term interest rate to above the rate of inflation to entice savers to invest less in long term securities and hold more cash. Of course it's very hard to get this exactly right, as we'll see below.

The chart below reflects the assumptions of the treasury market over the course of the recent bull market in gold (2003- ):

Chart 1

(click to enlarge)

The real estate boom, 2002-2005. In the early 2000s, we can see that even though the short term interest rate (in green) was well below its equilibrium (and the rate of inflation) following the downturn of the early 2000s, the TIPS market was assuming that the Fed would get the balance basically right over time and the rate on the 5-year and 10-year TIPS were relatively stable around their equilibrium levels. In early 2004, the Fed started raising rates. Instead of its practice in 1994, when it raised rates to above equilibrium relatively quickly, the Fed embarked on a telegraphed, incremental program of raising rates.

The credit boom and real estate top, 2005-2007. It took a full year (until mid-2005) for short term rates to reach equilibrium. By this point the housing market was already going haywire and the credit markets were gaining a sense of false confidence due to the Fed's telegraphed game plan, even though it kept raising rates to above equilibrium levels. From this period until mid-2007 long term real interest rates also rose to an above-equilibrium level as investors felt that the investment wave was strong enough to withstand an extended period of above-equibilirium short term rates.

The bust and the aftermath, 2007-2009. Of course that is not what happened. Higher short term interest rates eventually made real estate investment less attractive. Construction peaked in 2006 and prices peaked shortly thereafter. More and more marginal loans were being made and the credit allocation system was far more fragile than investors realized. As the credit market started to unravel, the Fed started cutting rates and long term real rates started to fall, touching very low levels in early 2008. During the height of the credit crisis in late 2008 and early 2009, long term real rates reversed and spiked as the market feared uncontrolled deflation, but then quickly dropped again as they realized that the Fed was on top of things and willing to do what it took to keep inflation positive.

The "U" shaped recovery, 2009 – 2013. In the period since, private investment in general, and real estate investment in particular, has been very weak, so demand for cash for long term projects has also been weak. The Fed has been aggressive about keeping rates below inflation and about reducing the cost of capital of long term securities. Even though businesses have returned their levels of investment to more normal levels, real estate investment has remained at abnormally low levels while excess capacity from the boom was worked off. During this period, investors came to the conclusion that investment would be abnormally weak for a long time and that the Fed would thus have to hold rates below inflation for a long time. The 10-year TIPS yield has been negative, implying that we would be in this state of affairs for 10 years or more on average.

Private investment

As we can see in the chart below, private investment relative to GDP was actually pretty healthy in the early 2000s when the Fed was erring on the side of being too easy. That was the major mistake that fed the housing bubble (in addition to their failing to recognize the excesses in the shadow banking system). After the credit bubble, on the other hand, investment fell to its lowest level since World War II. Thus the Fed has been correct to err on the side of being easy during the lackluster recovery.

Chart 2

(Click to enlarge)

Private investment, while improving, is only just above the level at which recessions usually bottom, so the Fed can be easy (i.e. keep rates below inflation) for a while longer without doing too much damage. The housing market has started to turn and housing has a long investment cycle. Investors can therefore see the economy returning to a relatively normal level over the intermediate term and not wallowing in the state of perpetual weakness that would necessesitate 10 years of negative real interest rates. It is the improving housing market, not the Fed's jawboning, that is causing long term real interest rates to rise.

Bringing it back to gold

OK, but real interest rates are still predicted to be negative over the next five years and the Fed's rate hikes are a year away at least. So why is gold falling now?

The market for gold, like the one for treasury securities, is focused on the future. For a long time the people focused on gold were very different than those involved with the more mainstream fixed income markets. In the early 2000s, gold had gone through a 20 year bear market and had been left for dead by all "respectable" market participants. During the high real interest rates of the technology investment boom of the late 1990s, gold had fallen to under $300 per ounce. The people that followed gold at that point were mainly ideological…people who hated paper currencies.

Gold bugs are contrarians that think an economy built on paper currency is a castle made of sand. I know, because as I was investing I gold during the early and mid 2000s, I used to traffic gold bug websites. Because there was no greater castle of sand than America riding the dot com bust, followed by the Iraq War, followed by the housing bubble, all on the back of a falling dollar and Chinese imports, the gold bug crowd was having a contrarian field day in the early 2000s.

The gold bull market had three phases that correlated with the the phases of the treasury market described above. The first phase lasted until about early 2006. As the Fed eased policy and the dollar declined from its lofty levels of 2000, the price of gold normalized to its old level of $350-$400 per ounce that held before the tech bubble. In late 2005 and early 2006, the gold market recognized the Fed's mistake of feeding the credit bubble with its telegraphed policy and that the housing market would eventually fall, necessitating a major Fed easing. It was during this period that the price first spiked to $600+, signalling a real bull market.

Chart 3

(click to enlarge)

Gold had a hard time rallying in 2006 and 2007 as real interest rates were high, but it held its ground as it rightly anticipated that there would be a recession and real interest rates would fall again. Then by early 2008, gold investors realized that the credit bubble was even worse than they thought, and prices spiked to $1000 per ounce anticipating a massive Fed rescue.

In late 2008 and early 2009, however, the market feared that the Fed may be erring on the side of being too tight, and real interest rates spiked and gold fell to below $800 per ounce. Then the Fed and the Treasury Department rode to the rescue and the gold and TIPS bull market resumed. As can be seen in Chart 3 above, the gold market has done a pretty good job of anticipating the decline in long term TIPS yields (shown on an inverted scale).

In 2011 and 2012, these markets started topping out for fundamental reasons. The economy is improving, the Fed has not proven to be overly reckless, price inflation is quiescent and it has gotten pretty tough to justify buying long term TIPS at a yield of negative 1%. Gold bugs point to consipiracies and treasury investors can blame the Fed, but it was time for real rates to rise and the smart money started getting out of both gold and TIPS.

So what's the right price for gold?

In a bear market that follows a big bull market with three upwaves and two consolidation waves, you figure the bear market wipes out the last upleg or "extended fifth wave". That would take us down to the $800-1000 range.

The other old rule of thumb is that an ounce of gold over time is about equivalent to the price of a "decent man's suit". This follows the store of value or neutral currency notion. When I was gruaduating from college and starting work, a suit at Brooks Brothers cost about $350, about equal to an ounce of gold. The price of a Brooks Brothers suit today…$1000 (interestingly, currently marked down to $700). Sounds about right.

I am not your financial advisor. These posts and the observations therein are written purely for the author's pleasure. Please consult your own financial adviser before making any investment decsions.