US NATIONAL DEBT

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More Irrational Thinking

March 22, 2010

Jeffrey Nichols, Senior Economic Advisor to Rosland Capital

Managing Director of American Precious Metals Advisors


Gold's latest breakdown below $1,100 an ounce seems like a big deal -- worrying gold bulls, vindicating gold bears, and giving market analysts and financial journalists something to write about. But, in reality, gold has been fairly stable in recent weeks, trading in a range between $1,090 and $1,140. Few get excited when a $10 stock moves up or down 50 cents, but every wiggle in the yellow metal's price seems to garner much attention.

Although gold remains vulnerable on the downside, we believe the long-term trend remains the investor's friend. The next really big move -- say in excess of 10 percent (or more than $100) from current price levels -- is much more likely to be on the upside.

In the meantime, smaller moves up or down in the price of gold are really no more than noise, as gold traders and speculators react to the latest news or technical triggers, but mean little for gold's long-term prospects.

So far, today (Monday), gold seems to be holding up well. The move below $1,100 has not yet generated another round of technically inspired speculative selling . . . and does not seem likely to do so. Instead, the metal has bounced off its lows near $1,090 and moved back above the $1,100 level. If it holds above this psychologically important round number for a few days, traders and speculators could quickly kick the metal higher.

Judging from Monday morning's news accounts, two developments may explain this morning's swift price decline:

First, German Chancellor Angela Merkel cast doubts over the weekend that the European Community was ready to provide financial aid sufficient to prevent a default on Greek sovereign debt. This led to a decline in the euro, Europe's common currency, in early trading this morning and gold fell in tandem as the dollar appreciated.

Second, this past Friday, India's central bank, the Reserve Bank of India, unexpectedly increased its key policy interest rates to restrain excessive economic growth and temper domestic inflation. Historically, India is the world's largest gold-consuming market -- and some believe any tightening of monetary policy will temper the country's gold demand.

If these two developments were indeed responsible for today's quick decline in the price of gold below $1,100 an ounce, we think the market has again got it wrong. One thing about financial markets -- no matter how wrong they may be in the short run, in the long run, they are always right.

First, the U.S. dollar is appreciating not because the American economy is the picture of health nor because U.S. monetary and fiscal policies are instilling confidence in the long-term value of our currency. If this were the case, yes, gold prices ought to be heading down. But it is not!

Rather, it is the euro that is depreciating against the dollar because the European economic situation is even worse than ours and because the euro's very survival is now being questioned. Indeed, the race between the greenback and the euro is a race to the bottom, not to the top. And, regardless of which one win's the race to the bottom, gold will, before long, be moving up in both currencies.

Second, with regard to India's monetary tightening, the Reserve Bank's objective is to keep the economy growing at a good pace over the long term. A sustainable expansion in economic activity with rising household incomes and increasing prosperity will result in more demand for gold jewelry and investment across India.

Importantly, Indian gold demand is very price sensitive -- but it is the local rupee price that matters to Indian consumers and investors, not the dollar price in the world market. With the country's monetary and interest rate policies resulting in an appreciating rupee, the local gold price will be more attractive to India consumers and investors.