The message of gold

Gold is down 18% from its summer highs. The euro has dropped 12% against the dollar since April, while the yen has risen almost 10%. These all sound like big numbers for such a small time span, but the chart above shows that they are mere ripples in a very large pond.

The big story here is that all currencies have depreciated massively in terms of gold over the past decade. Some (like the yen) by less, some (like the dollar and the euro), by much more. In yen, gold is worth less today than it was at its early 1980 peak (one third less, to be exact); in dollars, gold is worth 90% more.

The relative worth of currencies tells us a lot about the underlying inflation fundamentals of each. As this chart shows, the dollar has fallen massively relative to the yen since 1978, with the yen soaring from 240/dollar to 78. This fact alone dictates that the dollar has suffered from much more inflation than Japan. So its not surprising that since 1978, U.S. consumer prices have risen 264%, while Japanese consumer prices have risen only 50%. Since the dollar has fallen 30% against the DM over that same period, it makes sense that German consumer prices have risen by 40% less than U.S. consumer prices (115% vs. 264%).

Gold is a good reference point to compare the relative behaviors of currencies (A Gold Polaris, as the late Jude Wanniski put it), and arguably, it also tells us about the market's future expectations for how currencies and their purchasing power are likely to behave. Since gold has risen significantly against all currencies in the past several years, that tells us that the market is expecting inflation in all countries to rise in coming years. Since gold has risen the least in terms of yen, that implies that the market expects the yen to suffer from much less inflation than most other currencies.

As I see it, the huge rise in gold in dollar terms in the past decade was the market's way of worrying that U.S. monetary policy was adrift, no longer tied to something like a Taylor Rule, and instead more focused on promoting growth and bailing out banks and debtors at the expense of sacrificing purchasing power. The dollar's rise against the euro since last April, while both have fallen relative to gold, is the market's way of saying that the Eurozone sovereign debt crisis is changing the outlook for ECB monetary policy: the ECB has become a less reliable advocate for low inflation and is now instead more likely to succumb to pleas to bail out the southern European nations by running the printing presses faster.

Meanwhile, the dollar of late has benefited at the expense of the euro not only because the ECB seems to be losing its independence, but also because the U.S. economy is gradually decoupling from the problems of the Eurozone. U.S. growth has been gradually picking up (though still painfully slow), while the Eurozone economy has been slowing down; U.S. stocks have outperformed Eurozone stocks by 25% over the past year. But I hasten to add that the price of gold today is still pointing to the very real risk that the U.S. government will resort to the printing press to help address the looming problem of out-of-control spending and soaring debt burdens.

How to explain the fact that gold prices have fallen 13% in dollar terms, 16% in yen terms, and 11% in euro terms since gold hit its all-time highs last September? I'm going to guess that the across-the-board selloff in gold may be an indication that the market was priced to Armageddon last September—a global depression and massive monetary and fiscal policy uncertainty—and is now seeing that while things are still bad, the end-of-the-world-as-we-know-it is not inevitable (e.g., the U.S. economy is slowly improving, the political winds are moving in the direction of less profligacy, even in Europe). Others might say we are simply seeing the forced unwinding of massive and leveraged gold speculation, but I think there is a fundamental explanation in addition to a technical one.