2000 per oz

Prediction from Eureka report's Charlie Aitken :
gold could rise to $2000 / oz


History shows all secular bull markets for gold have been the direct result of a corresponding bear market for the US dollar. In this context the current gold bull market began in 2001 with the beginnings of a long bear market for the US currency.

The last major bull market for gold resulted in the gold price rising more than 2300%, from $US35 an ounce in 1970 to $US850 in 1980. In the current bull market, the gold price has risen by about 300%, which is small by comparison. For Investors believing the gold price is close to a peak in the current cycle it is worth a reflecting on the performance of the commodity in the last great secular gold bull market in the decade between 1970 and 1980.

In addition, it is also worth noting that the oil price has just eclipsed its inflation-adjusted high of $US103.56 a barrel set in 1980. However, the previous record gold price of $US850 an ounce is $US2240 in today’s dollars. Ultimately this level may not be achieved but, hey, records are made to be broken. The oil price is clear proof. The same factors evident in the decade to 1980 are in place and gold has the potential to rise significantly from current levels.

I have traced the origins of the inverse relationship between gold and the US dollar in previous editions, but it is worth briefly reflecting on the correlation again considering there are some eerie similarities between the lead-up to the previous 1980 record high and the current situation.


Reserve currency

In the late 1960s, the US ran huge budget deficits to fund the massive cost of the Vietnam War. After running continual trade account deficits, by 1970 the US held just under 16% of international reserves, down from 65% in the 1950s. At that time, the Bretton Woods agreement had established the US dollar as the world's "reserve currency", being convertible into gold at $US35 an ounce. In addition, the major global currencies were fixed or "pegged" at varying rates to the US dollar.

However, as the trade deficits increased, international reserves and US gold outflows accelerated to fund the sharply rising current account deficit. In addition, the volume of US dollars in circulation soared as the printing presses worked overtime to fund the war. As a result the US dollar became massively overvalued relative to gold, causing a crisis in confidence in the it as the world's "reserve" currency. Consequently President Richard Nixon rescinded the US dollar's convertibility to the fixed price of gold and the newly floating gold price rocketed.

In the aftermath, gold peaked at $US850 an ounce in May 1980, when inflation soared after the three oil shocks resulted in OPEC tripling the price of oil, and the US dollar entered a 10-year bear market after losing its "reserve" currency status. I believe the stars are aligned for gold again, considering a confluence of similarly bullish factors is currently in place mirroring the decade of the 1970s.


Trade and budget deficits

First, the US Government is running massive trade and budget deficits similar to the 1960s and 1970s. In 2007 the US trade deficit of $US711 billion, or 5.1% of GDP, narrowed slightly from $US763 billion in the previous year. On the surface the decline appears to be a positive but this slight improvement masks a disturbing trend. Since 1996 the US current account deficit (trade deficit plus interest) has soared from 1.6% of GDP to 5.1%. This has occurred despite a 30% fall in the US dollar’s trade-weighted index. Clearly the US economy has major structural problems.

The fiscal 2009 budget presented to Congress in February will be the first to top $US3 trillion, and the budget deficit is set to increase to $US407 billion up 150% from $US163 billion last year. However, the 2009 estimate does not include the recent $US160 billion emergency package or the additional $US70 billion allocation for the war on terror. In addition, the Congressional Budget Office estimates that the future $US1.7 trillion in tax cuts and the $US800 billion for the wars in Iraq and Afghanistan will result in the budget deficit blowing out to more than 5% of GDP by 2011. The sharp deterioration in the US trade and budget deficits are scarily similar to the 1960s and 1970s, which spawned a long-term bear market for the US dollar and an all-time record gold price.


$US diversification

Second, similar to the 1970s decade, it appears that the US dollar is losing its status as the world's "reserve" currency. Recent figures reveal that Asian central banks, which previously have been recycling massive trade surpluses into US bonds, are now diversifying away from US-denominated assets. Last year's US Treasury figures reveal a steady decline of global central bank purchases of US bonds.

In addition, the oil producers are now diversifying away from $US petrodollar reserves, according to figures from the International Bank of Settlements (IBOS).The figures reveal OPEC holdings of US bonds fell by 10% in the last quarter. Russia, the world's second largest oil producer after Saudi Arabia, has recently announced the intention of a switch in trading Ural blend oil from US dollars to roubles.

The US dollar has fallen more than 30% on a trade weighted basis since 2001, with further falls expected. In addition, major holders of US dollar foreign exchange reserves are diversifying. It is worth noting that the Asian central banks and the global oil producers control the majority of the $US5 trillion in global foreign reserves. Figures from the IBOS reveal 60–65% are in US bonds, which effectively fund the US trade deficit. If the $US2 billion in daily capital inflows required to fund the trade deficit begin to decline, then the outlook for US interest rates and the US dollar starts to deteriorate badly.


Currency pegs

Third, similar to demise of the Bretton Woods agreement in 1970, where countries abandoned their fixed currency status with the US dollar, the Asian and oil-producing countries are now facing increased pressure to break their "pegs" to the US currency.

In Asia and the Gulf states the fixed currency "pegs" are resulting in massive capital inflows, which are exacerbating already rising inflationary pressures. In the United Arab Emirates and Qatar, inflation is running at 12–15% while Chinese inflation has surged to 6%. I think it is inevitable that countries with fixed exchange rates force a Bretton Woods Mark 2 by abandoning US dollar currency pegs resulting in global currency instability and threatening the US dollar’s status as a "reserve" currency. The end result will be a loss of faith in paper currencies and a switch into hard assets such as gold. I think this is already happening.


US dollar liquidity

Fourth, another factor reminiscent of the environment supporting the last secular gold bull market in the 1970s is the massive increase in the volume of US dollars in global circulation. Similar to the massive funding cost of the Vietnam War, the cost of the wars in Iraq and Afghanistan has risen to $US800 billion and is accelerating rapidly. As a result, the Treasury is issuing US dollars and bonds to fund the massive cost increase from the original estimate of $US75 billion. Budget figures reveal US Government spending has increased by 25% since President George Bush came to office in 2001.

In addition, in an attempt to alleviate the sub-prime problems and avert a global credit crisis, world central banks have flooded the international financial markets with an unprecedented $2 trillion in liquidity. The US Federal Reserve has been the main culprit, injecting an estimated $US1.6 trillion in liquidity since September last year. As a result, the global broad money supply, predominantly in US dollars, is currently increasing by 10–12% annually.

The US Treasury's printing presses are working overtime again, flooding the world with US dollars, which is further exacerbating the devaluation of the US currency and the status as the world's "reserve" currency. History shows a loss of faith in paper assets supports strong outperformance by precious metals and commodities.


Oil shock

The final contributing factor culminating in gold peaking at $US850 an ounce in 1980 was the massive increase in the oil price. In three successive OPEC oil shocks in the 1970s and 1980s, the oil price rose more than three-fold to nearly $US40 barrel. As a result global inflation, particularly in the US being the world's largest oil consumer, soared to levels approaching 14% in 1980. Fast forward to the present and it is scarily similar that the oil price has just risen to an inflation-adjusted record high.

The latest US producer and consumer inflation figures are surging due to the inflationary pressures of the rising oil price. The latest reading on US producer price inflation is running at 7.5%, the highest in 26 years. In addition, headline inflation, including oil, rose to 4.3% in January, while the personal consumption indicator index, the Fed’s preferred measure of core inflation, has just risen to 3.7%, the second highest level since the series began.

However, despite the similarities to the last great secular bull market for gold in the 1970s, there are a number of additional factors supporting our expectation of significantly higher gold prices in the current gold bull market.


Interest rate differentials

At the recent FOMC meeting, US Federal Reserve chairman Ben Bernanke mentioned the risks to US growth at least five times while acknowledging the upside risks to inflation once. Clearly the Fed is committed to strong US economic growth, at the expense of inflationary pressures, which are accelerating quickly. Consequently, there is a very good chance that the Fed will cut the Federal Funds Rate by another 50 basis points, to 2.5%, at the next meeting in March. This will significantly weaken the interest differentials with the Euro to 150 basis points and other major currencies .The effect is to encourage additional "carry" trades, further weakening the fundamentals of the US dollar relative to its major trading partners.

It is no surprise that the recent surge in the gold price to nearly $US1000 an ounce has occurred after the latest 50 basis point rate cut, and the 225 basis point reduction in US rates since September last year. There are, no doubt, the "cheap money" policies of the Fed with the Federal Funds Rate at 1%, significantly increased US money supply spawning the sub-prime crisis and the current gold bull market. However, it appears Bernanke is determined to exacerbate the devaluation of the US dollar by making a similar mistake. The Fed’s recent actions have fuelled a significant increase in inflationary pressures and have underwritten a massive long-term bull market for gold.


Declining mine production

Global gold production has been flat to declining over the past decade. In fact, last year mine supply fell 1% year on year to an 11-year low. In 1997 world production totalled 2493 tonnes, however last year mine supply fell to 2474 tonnes.Supply from South Africa declined last year to the lowest level since 1932, while AngloGold recently warned output is expected to fall 7% or 400,000 ounces this year due to power issues.

Surbitron reports that Australian gold production fell 1% last year to 248 tonnes. Last year, releasing its fourth-quarter result, Barrick, the world's largest producer, revealed production had fallen 12% and, looking forward, the company expects 2008 production of 7.6 million ounces to 8 million ounces, compared to last year’s 8.06 million. In addition, Barrack forecast a 10–15% decline in global gold production over the next five to seven years. Chief executive Gregory Wilkins said: "Global mine supply is going to decrease at a much faster rate than people generally believe." I think as long as world governments and central banks continue to allow the global money supply to increase by 10–12% a year and mine supply continues to fall, gold will continue to outperform paper assets.


Central banks and ETFS.

Over the past few years, central bank selling has been alleviating falling mine production but there are signs this process is reversing. Under the latest five-year Central Bank Gold Agreement, which ends in September 2009, banks agreed to cap gold sales at 500 tonnes a year. However, 2006 was the first year since the inception of the agreement that central banks failed to meet their quotas, selling 388 tonnes .Last year Gold Fields Minerals Services (GFMS) estimated central bank sales rose to 488 tonnes, still below quotas. This year GMFS expects lower sales again with a forecast for the six months to June of just 200 tonnes .The incredible investment growth of gold through exchange traded funds (ETFs) has resulted in a significant new demand source, complementing jewellery demand. Last year ETF holdings reached 834 tonnes, which represents the seventh-largest world gold holdings.


Gold at $US2000

I have been bullish on gold since 2002 despite much scepticism at various times. The current gold bull market began at the end of 2001. It is worth noting the spot gold price has risen 256% in just over six years, from $277 an ounce on January 4, 2002, to $US988 an ounce last night. Over the same period, the S&P 500 index is up 14% from 1177.

It now appears the gold theme has universal support .This is slightly concerning, but gold is entering the second stage of a long-term bull market, with each stage more powerful.

The first stage is supported by weakness in the "reserve" currency; the second stage is the outperformance of gold against all currencies. I think economic weakness in the EU will eventually undermine support for the Euro, resulting in a lack of faith in paper currencies, and gold will substitute as the hard currency equivalent. The third and most powerful stage for gold is characterised by rampant global inflation. In May 1980, when gold reached the previous record high of $US850 an ounce, US inflation peaked at 13.9%.

Currently US inflation is 4.3% and accelerating rapidly, driven by massive US Government defence spending, irresponsible monetary policy by the Federal Reserve and rampant commodity prices. Sound familiar? At the Diggers & Dealers conference in 2006, Newmont chief executive Pierre Lassond famously stated that he was sure the gold price would start with three zeros but he was unsure of the first figure. I agree gold could rise significantly and $US2000 an ounce is achievable.

I continue to recommend Newcrest as my major preferred big-cap play, with a target of $42, up nearly 10% from current levels. Southern Cross’s new resource analyst, Fleur Grose, has a positive view on Lihir (LGL); stand by for more news in that space. In the small caps, St Barbara is my preferred play, with a target of $1.20, up 36% from here. Peter Chapman believes St Barbara is an outstanding growth story, with annual production expected to grow from the current 170,000 ounces to 450,000 in 2009.