Centennial Precious Metals, Inc: Serving Gold Coin & Bullion Investors Since 1973

3/28/05

A publication of USAGOLD-Centennial Precious Metals
Serving gold investors since 1973

"Below the favorable surface, there are as dangerous and intractable circumstances as I can remember. Nothing in our experience is comparable, but no one is willing to understand and do anything about it. We are consuming about six per cent more than we are producing. What holds the world together is a massive flow of capital from abroad. It is what feeds our consumption binge. The United States economy is growing on the savings of the poor. A big adjustment will inevitably become necessary, long before the social security surpluses disappear and the deficit explodes. We are skating on increasingly thin ice."

Paul Volcker, former chairman of the Federal Reserve

Overview:

Inflation reared its ugly head this past week but the results in terms of the gold price were unexpected. Inflationary concerns usually push the yellow metal higher and equities lower, but this time when the Fed used the "I" word, gold tracked lower along with stocks and bonds. Interestingly, many Wall Street analysts (like CitiFX) believed the Fed would distance itself from the "measured pace" rhetoric and pave the way for a .5% increase, but it didn't. It kept the "measured pace" language but added that "inflationary concerns" were now heightened. That was enough to send Wall Street into tizzy.

But as far as gold goes, should it have?

The old school will tell you that inflation needs to be weighed in a larger context -- one that encompasses real rate of return. (A yield bearing asset shows a real rate of return when its interest rate exceeds the inflation rate after taxes.) Currencies with a positive real rate of return attract investment capital, and they rise. Currencies with a negative real rate of return experience an exodus, and they fall. At the moment, even with a further .5% interest rate increase come May, the dollar isn't even close to producing a real rate of return.

So while last week's drop in stocks and bonds made at least some sense, gold's decline made no sense whatsoever. But who says investment markets need to be logical? The fact that they are illogical makes them markets -- producing profits for some and losses for others. Ultimately, cooler heads will prevail in the gold market.

"We question the simplistic view," says Tony Norfield of ABN Amro, "that just because Fed funds are going up more than rates in other countries, that will give the dollar support. The knee jerk reaction has been to buy the dollar, but the medium-term impact could yet be negative."

With the inflation rate in the United States bumping up against 5%* and average yields in the vicinity of 3% before taxes, the dollar is still some distance from being the capital magnet it once was. And prices, the other side of the real rate of return equation, cannot be expected to stand still under the circumstances. Imports -- formerly the restraining factor in the inflation scenario -- are now getting pricier (See graph). Expert consensus sees energy, the chief driver in import prices, as unlikely to come down significantly any time soon. To the contrary, as we saw Friday after the refinery explosions in Texas and New York, oil remains ultra-sensitive to any development likely to threaten supplies of either crude itself or its finished products like gasoline. Even in China, where the ability to manufacture cheap goods has been the bulwark of the low inflation scenario, sustained higher oil prices will drive the cost of manufacturing higher and along with it export prices. All of this puts the inflation scenario on pretty solid footing and the Fed in a catch-up mode.

Morgan Stanley's Stephen Roach has a similar take: "In an era of fiscal profligacy, real interest rates are the only effective control lever of macro management. It is important to stress the 'real' dimension of this construct -- the need to strip out the money illusion associated with fluctuations in the price level and focus on inflation-adjusted interest rates.  From that simple vantage point, America's central bank is swimming upstream.  Measured tightening is being largely offset by a measured increase in underlying inflation -- muting the impacts of the Federal Reserve's efforts to turn the monetary screws."

We may see a whole different set of market conditions by this time next week. With bond market capital looking for a place to go, gold, not the dollar, could become an increasingly inviting target market for international money.

One final point: The Federal Reserve fundamentally is not at odds with the Bush administration's dollar policy and that needs to be blended into the analysis as well -- that policy favors a cheaper dollar despite Treasury Department rhetoric to the contrary. Therefore, we see great merit in the argument that the trends in place prior to last week's Fed meeting are likely to reassert themselves once the smoke clears. MK

* The Labor Department last week reported .4% rise in consumer prices for February.

Related: Gold may rise, spurred by speculation inflation will accelerate (Bloomberg 3/28/05)

Near death experience temporary; gold shall rise again
by Eric Fry

The bad news is that Alan Greenspan thrust a semantic stake through the heart of the gold market...or so it has seemed since last Tuesday. The chairman's quarter-point rate hike ­ and his accompanying verbiage ­ stunned the gold market, while also rocking most other financial markets. But despite gold's near-death experience this week, we suspect it will rise again...along with most other commodity markets. The commodity bull market might be out of breath, but we doubt it will suffocate.

Last Tuesday, around 2:15 Eastern Time, the benign American financial environment suddenly assumed a very menacing demeanor. At that very moment, Chairman Greenspan hiked short-term interest rates one-quarter point to 2.75%. Within minutes, investors rushed to sell stocks, bonds, oil, gold and every other financial asset that wasn't bolted to the floor. By day's end, the Dow had dropped nearly 100 points, crude oil had slipped nearly two dollars from its high and gold had tumbled nearly 10 dollars.

The Fed's itty-bitty adjustment to its itty-bitty interest rate should not have produced such a mess. After all, nearly every economist and investor in the land had anticipated this exact move. Apparently, however, all these economists and investors were not prepared to learn that the chairman considered inflation to be a problem.

Full article: "The Rude Awakening"

Short & Sweet. . . . . . . . . . . . . . The United States added another $10 billion to the national debt this past week putting the total at $7.784 trillion. On March 1, 2005, the figure stood at $7.701 trillion. Will March 2005 be the first $100 billion month on record?. . . . . . . . . . . . . .Standard and Poors - the bond rating service - declares that "rapidly rising pension and healthcare spending will reduce the debt status of the world's richest industrialized countries (i.e., the United States, UK, France and Germany) to junk within 30 years unless their governments move quickly to balance budgets and reduce outgoings.". . . . . . . . . . . . .Bridgewater Associates: "We believe that the U.S. is moving toward a balance-of-payments/debt crisis that is similar in its dynamic to the dollar/debt crisis of 1968-71 that led to the break-up of the Bretton Woods monetary system." . . . . . . . . . . . . . Much of the stability in the value of the euro vis a vis gold has to do with the European Union's stability pact which prohibits the various members from running budget deficits over 3%. Over the past few weeks, the stability pact has come under fire primarily from the French and German governments -- a circumstance which led to a agreed upon relaxation of the rules. Reflecting the uneasy relationship between the various governments and Europe's central bankers, Bank of England's Mervyn King told Financial Times, "Finance ministers have driven a coach and horses through the pact. My central bank colleagues in Europe are seriously concerned indeed. I think dismayed would be a better word." . . . . . . . . As Tocqueville's John Hathaway points out below when gold begins to go up in euro terms gold will attract big time investment capital now parked in all currencies. Tossing the stability pact in the air might be the official starting gun to the process. . . . . . . . . . . . . . . . Newsday reports the following year over year increases in the cost of breakfast and gasoline: White bread, 1 lb. - $0.94/$0.98 ( Up 4% ); Bacon, 1 lb. - $3.19/$3.40 ( Up 7% ); Whole milk, 1 gallon - $2.81 / $3.18 ( Up 13% ); Butter, 1 lb. - $2.79/$3.53 ( Up 27% ); Coffee, 1 lb. - $2.86/$2.94 ( Up 3% ); Grapefruit, 1 lb. - $0.67/$0.99 ( Up 47% ); Regular unleaded gas, 10 gallons - $18.77/$21.37 ( Up 14% ) . . . . . . . . . . . . Phyllis Schafly: "The real purpose of CAFTA [The Central America Free Trade Agreement] is to allow multinational corporations to exploit the abundance of cheap labor and the scarcity of taxes and safety regulations in CAFTA countries. CAFTA will increase our $58 billion job-killing U.S. trade deficit and further weaken our already suffering dollar."

World Gold Council publishes latest official sector gold stats

Those of you with an interest in official sector (i.e., central bank and international institution) gold sales will find much to read between the lines in the latest World Gold Council official sector statistics - and most of that translates to positives for the future price. Let me elaborate briefly. France, the Council reports, is an active seller under the Central Bank Gold Agreement (CBGA)* and has been since last October. Thus far France has sold a total of 46.9 tonnes with half of that coming on market in November, 2004. France is scheduled to sell 500 to 600 tonnes under the agreement from 2004 to 2009. Switzerland - by far the largest seller under the previous 5-year agreement (at 22 tonnes per month) - has completed its sales. Germany has withdrawn from the 2004-2005 schedule passing its option to "another Eurosystem central bank." Netherlands, which has been a primary seller for a number of years, will sell only 165 tonnes in the five year period. Belgium, another primary official sector source in the past, is absent from the schedule. Russia informs the gold market community that it will be increasing its gold holdings to 10% of total reserves over the period. Austria plans to sell up to 90 tonnes over the period; Sweden 60 tonnes. The total announced sales scheduled thus far amount to only 880 tonnes out of the 2500 tonnes allowed.

Analysis

There is much discussion in gold and forex circles about how much of the 500 tonne annual gold sale allotment under the CBGA will actually reach the market. And rightly so. If the substantial shortfall now in place were to stand, it could put a crimp in the physical market supply and send bullion institutions short the metal into a scramble to nail down available supplies. With Switzerland now having completed its long-term sales program and Germany withdrawing as a seller, gold analysts are stretched to foresee sources for meeting the agreement's objectives.

As most of you already know, a Brtish-sponsored effort to convince International Monetary Fund members to sell (or revalue) that institution's gold holdings (3217 tonnes) has met with strong opposition from the United States which holds veto power over IMF actions. It comes as a surprise that France is actually selling the metal (there was previously some question) but there are also rumors afloat that France has decided to curtail its sales operation as well. There is no clarification of the rumors in the World Gold Council report.

At the moment, it appears that overall official sector selling under the CBGA will come in under the 500 tonne figure and possibly, if no significant seller steps into the breach, considerably under that figure in the future. This will translate to a major positive as the year proceeds especially if some political or economic event ramps up physical demand.

As for the longer run, even if the central banks manage to muster the 500 tonnes called for in the agreement, dehedging, central bank buying operations and international investment demand will more than pick up the slack. Beyond that Japanese and Chinese official sector demand still looms in the background. Those countries' undersized gold holdings make them likely buyers should any significant holding (like the IMF's) be put on the market. Historically, the official sector gold sales have always produced more smoke than fire in terms of market effect. Historically the greatest rewards have gone not to the sellers, but to those who saw the sales as a buying opportunity. MK

* Those of you new to gold investing will find an overview of the Central Bank Gold Agreement and its potential ramifications in "The ABCs of Gold Investing: How to Protect and Build Your Wealth with Gold". That volume will provide a foundation for understanding much of what is discussed in this newsletter in greater depth and detail in the weeks and months ahead.

The decay of all paper money and what you can do about it
by Chris Mayer

The British pound continued to weaken against the dollar over the ensuing years. [Author Justin] Mamis notes: "Weakness, in a long-term sense, begets weakness, like the flaws in an incestuous genetic pool."

The dollar has been the world's reserve currency, or currency of choice, since at least Bretton Woods. From this short collection of historical vignettes, we can make one safe assumption. As Mamis puts it, the status of being a "reserve currency is not a permanent appointment."

To pinpoint when the dollar's status as the world's currency of choice will end is an impossible task. These things tend to unfold over many years, and there does not appear to be any immediate contender ready to ascend to the throne. But that should not deter the investor from making the basic assumption that the dollar of a decade hence will buy less than a dollar of today.

I'll include one last quote from Mamis, who advises us not to expect long-term trends to always be immediately apparent or obvious. "We must warn not to turn the next century's global changes into something that has to be evident in its entirety all at once - or else denied. Nor will our concerns be proven instantly 'wrong' because the dollar finally has its oversold rebound." Well said.

This situation - the whittling away of the dollar - creates the need for sound investing. Basically, investors look to survive the ravages of inflation (and taxes - of which inflation is a most insidious type). Like the biting winds of nature that sculpt rock and carve stone, inflation and taxes will grind the greatest piles of fortune to dust over time. Preserving it, making it grow - essentially investing well - is the investor's difficult art.

So should you put your money in euros, perhaps, or some other foreign currency? The euro may strengthen against the dollar, but I think the dollar and the euro share the same fate, like the passenger pigeon and the Carolina parakeet. The road to extinction may be of indeterminable length, but the final destination of that road is not in doubt. The same can be said of all our paper currencies, be they yen or pounds, pesos or ringgit. All of them are on the same slide.

But there are other ways to beat the decaying paper currencies that make up so much of our financial wealth. The idea of tangible asset investing, investing in stuff that has survived and prospered in a variety of conditions, should meet the challenge in the years ahead."

Full Article: "The Decay of Paper Money"

A sure thing
by Richard Russell

"A few days ago, my wife Faye, asked me, 'Richard, if you had to chose only one item to hold, and you had to hold it untouched for the next ten years what would you pick? You can pick dollars, a stock, a diamond, a home, anything, what would you pick?'

I thought for a minute and answered, 'Gold. I'd pick gold because in ten years anything can happen. The US could be booming or it could be in the depths of depression. I thought of my five kids and where they might be. In the end I decided that the only thing 'sure,' at least in my opinion, was that gold would continue to represent wealth.

Yes, I picked gold, and I have no idea what it would be worth in terms of dollars -- assuming dollars were still a currency at all. End of that story.

By the way, speaking of dollars, in my opinion the only thing that has allowed the US to remain 'prosperous' rather than 'bankrupt' is the fact that we own the world's reserve currency. Thus, the US can pay off its international debt in a currency that it alone creates. No other country in the world can do this.

This will 'work' as long as the rest of the world is willing to accumulate dollars. As I see it, the trend is already turning against the international accumulation of unlimited quantities of dollars. As long as the US deficits continue, the US will continue to export dollars. But the trend is changing."

Dow Theory Letters

The first leg of a multi-year bull market
by John Hathaway

"A likely side effect of the inevitable central bank migration away from the dollar will be further appreciation of the euro against the dollar.  Let us see what European politicians have to say when one euro buys 1.40 or 1.50 US dollars.  Their attempts to explain how further deviations from the Stability Pact and market interventions will not undermine the value of their beloved euro should make for highly entertaining comedy. 

It is against such a backdrop that the euro price of gold should surpass the trading range of the past two years.  A breakout in euros will serve notice to the market that gold is not a subset of the weak dollar play.  Once it has crossed this threshold, gold will begin to attract capital from assets parked in all currencies and asset classes including commodities and high yield credits, the two most recent investment bubbles.  The bull market in gold, which commenced in August of 1999, will shed its stealth mode.  Its pace will quicken and become difficult to ignore.  We stand at the end of the beginning of the first leg in a multi year bull market in the metal.  The significant accumulation that has occurred during the past five years will not yield easily to the sharply higher prices that lie ahead, because those price gains will be spurred by financial market developments that make gold's appeal quite obvious, even to its detractors."

Full article: "Euro Trash"

Gold's annualized returns:

2002: +14.4%
2003: +17.3%
2004: +12.6%
2005: +3.0% (through 3/18/05)

2002-2004 based on average annual prices.

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mk@usagold.com