Gold's Day in the Sun

Gold's Day in the Sun
By James West

You've been hearing it for years.

"Gold's going to a thousand dollars an ounce!"

"Gold will outperform every other commodity this decade!"

"Gold could go to $5,000 an ounce!"

Well, it's starting to happen. Gold hasn't set any new records yet, but for the first time since the 1980s, gold is solidifying above $700 an ounce.

And everybody knows why. The house of cards that was easy credit, a massive trade deficit, and declining growth has all come crashing down. And as everybody keeps saying, it ain't gonna end any time soon.

 

The chart above is the Keefe, Bruyette & Woods Mortgage Index, ticker symbol MFX. This index is made up of mortgage finance stocks, with some pretty big names in the industry heavily weighted. Fannie Mae is 11%, Freddie Mac is 9%, Washington Mutual is 8% and Countrywide Financial is 5%.

It is a bottom-line performance snapshot of home mortgages. Recently we saw mortgage default rates climb to a level in the third quarter that was 14% higher than the second quarter of 2007.

According to a report last week from the Mortgage Bankers Association:

"Delinquency and default rates on loans and personal bankruptcy rates are still at comparatively low levels--only 4.7% of all loans in the third quarter--but they have been rising rapidly over the course of this year. Other measures of financial distress are also pointing one way for American families--up. With all pieces of the trifecta staying in place, rising delinquency rates on mortgages may be the beginning of a trend toward more middle-class financial insecurity . . .

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"The data on bankruptcy rates also show a worrisome trend over the course of 2006. Bankruptcy rates dropped precipitously in 2006 in the wake of large filings in 2005 just before the new bankruptcy law went into effect. However, from the first quarter of 2006 to the second quarter, the annualized personal bankruptcy rate, measured as bankruptcy cases relative to the U.S. population, grew from 1.2 in 1,000 to 2.0 in 1,000--an increase of 33.7%. The bankruptcy rate in the third quarter stood at 2.2 in 1,000, an additional increase of 9.6% in that quarter alone.

"Middle-class families are caught between low income growth, a high debt burden, and rising interest rates--and for the moment, these ingredients are here to stay. The most recent third-quarter delinquency, default, and bankruptcy figures show that the dangers to middle-class economic security are not theoretical concepts. They are a harsh reality for a growing share of middle-class families."

Countrywide announced Thursday that it had obtained another $12 billion in financing after borrowing $11.5 billion the week before and selling a stake to Bank of America for $2 billion.

You've got to ask yourself why an institution as blue chip as Bank of America would invest in the country's largest home mortgage lender just when everybody else in the sector is running for the hills.

It seems quite apparent to me that the only way Bank of America is going to ensure a lower default rate on its inventory of ABCP is to make sure that the so called triple-A assets behind the deteriorating paper continue to be financed. So it logically the bank has decided it's better to spend $2 billion than on an "investment" than to have an exponentially greater amount of debt go delinquent on its books.

Desperate times call for desperate measures, apparently.

Gold thus becomes more attractive. Crumbling credit availability means the oversupply of new housing and commercial real estate will curb demand, which will see prices drop. Larger institutional investors begin to see gold as a hedge against further US dollar drops and risk associated with credit.

Even Goldman Sachs has finally jumped on the gold bug bandwagon, publicly proclaiming that gold will reach $725 this year.

Meanwhile, central banks in the Middle East and Russia continue to add to their gold reserves, even while European and North American central banks keep selling. Many industry watchers think China is about to become a buyer of gold, as its massive reserves of U.S. dollars are looking like they could see pretty substantial devaluation in the months and years ahead.

Gold has doubled since 2002, even in the face of concerted central bank selling. When these banks start to run out of gold to sell, what will happen to the price-limiting effect of their selling? It's not unimaginable that gold could then start on an even steeper upward trajectory with no ceiling visible.

And then there's the gold "carry" trade. Gold is "borrowed" at a rate that is typically very low. The borrower sells the gold and invests the money in an asset that performs better than gold over time, then sells that asset and buys the gold back, supposedly at a profit.

This formula depends on a relatively stable gold price, because if the price of gold were to increase at a higher rate than the asset performance rate, a loss would be realized by the time the gold had to be returned.

So in this environment, nobody is going to want to lend or borrow gold, as its enhanced volatility represents elevated risk. Gold broke out of the year's trading range to resume a bull market, moving quickly from $670 to $721 in just eight trading days. A 7.6% gain in such a short time certainly got the attention of anyone in the carry trade business. So that business, and its net downward effect on the price of gold, is over.

Some analysts from otherwise conservative institutions think gold will see $850 by the end of 2007 as a result of desperate covers on short positions as the rate of gold price increase intensifies.

Meanwhile, Gold Fields Mineral Services, a global metals consultancy based in London, forecasts that total world gold-mining production will slip in the second half of this year. Gold sales by central banks, it says, rose by a modest 4% between January and July compared with the same period last year. Sales of so-called "scrap" gold--mostly recycled jewelry--fell by more than one quarter, despite spot gold prices trading at their highest six-monthly average in history.

Gold jewelry owners worldwide, in other words, want to hold on to the metal as its price continues to rise.

I, for one, am making regular trips to my local bullion bank to empty my wallet of paper currency for gold coins and bars. Somehow, it just seems to make sense.

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