dollar v gold

Equity Research
The gold price – Forget Cyprus and everything else, this is nothing out of the ordinary

Since its fix in London on Friday afternoon, gold has now fallen US$156/oz, or 10%, to US$1,379/oz at the time of writing. This decline effectively moves gold from a situation in which its price was discounting the continuation of QE3 at US$85bn per month until June, to one in which it is at a discount to the price implied by the current US monetary base.

Edison’s gold price forecasts are based on the statistically significant long-term correlation between the gold price and the total US monetary base, which was set out in full in our report, Gold, New benchmarks for old, published on 22 November 2012.

On 9 October, the Federal Reserve announced that it would purchase US$40bn of mortgage-backed bonds each month to stimulate the housing market and keep long-term interest rates low. Having grown by US$18bn in the previous month, the US monetary base grew by US$30bn in November, and then again by US$33bn in December – demonstrating that the majority of QE3 is feeding through to the monetary base in the conventional way. At the time, Edison forecast a long-term gold price of US$1,676/oz, on the basis that QE3 would last for a year until December 2013. However, in December 2012, with the ‘fiscal cliff’ looming, operation Twist coming to an end and economic growth still underwhelming, the Fed announced it would expand QE3 by an additional US$45bn per month (to a total of US$85bn per month) and keep interest rates close to zero until the US unemployment rate falls below 6.5% (vs 7.7% in November 2012 and 7.6% in March 2013), provided inflation does not exceed 2.5% and inflation expectations remain anchored. Since then, the US monetary base increased by US$67bn in January, US$104bn in February and US$88bn in March, again demonstrating QE3 adding to the monetary base at an average rate of US$86bn/month.

As at the end of March, the US monetary base amounted to US$2,934bn, which, on the basis of its long-term correlation, implies a gold price of US$1,524/oz (±US$133/oz). At US$1,379/oz therefore, gold is (in interpretive terms) more than a standard deviation below its implied price. Stated alternatively, if QE3 were to be stopped today, the implied price range for gold would be US$1,379-1,657/oz.

Therefore, the only question that remains is how long QE3 will last. In simple terms, QE3 at US$85/bn per month adds to the implied price of gold at the rate of US$40/oz per month. QE3 at its current rate to the end of June therefore implies a (mid-range) gold price of US$1,646/oz (±US$133/oz); QE3 to the end of September implies a gold price of US$1,769/oz, and to the end of December a gold price of US$1,891/oz. Stated alternatively, QE3 is worth approximately 3% to the (current) price of gold for every month it persists.

For the moment, therefore, Edison continues to maintain its gold equity valuations based on a long-term price of US$1,676/oz. The principal risk to its forecast is in the form of any rise to long-term US interest rates and/or any contraction in the monetary base (NB the US monetary base has contracted only once in the last half-century). Given continued lacklustre economic growth indicators from the US, Europe, Japan, and, significantly, now China, Edison deems this risk to be small.