Equity markets were hit by comments from the Federal Reserve chairman that indicated more interest rate hikes are possible. Ben Bernanke is worried that a slowdown in the US economy may not be sufficient to dampen inflation; hence the necessity to raise interest rates.
The equity markets are under pressure because higher interest rates reduce corporate profits and mean higher yields on debt investments, both bad for stocks. The economy in general suffers since corporations curtail investment spending and consumers take out less debt to finance their spending habits.
A recent report from the Fed showed that household debt increased at an annualized rate of 11.6% during the first quarter, so there is no indication yet that consumers have slowed down their accumulation of debt. Mortgage debt rose by $250 billion in the first quarter and home owners continue to cash out the equity in their homes.
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Interestingly enough, if we look at M3 data (that we calculate ourselves now since the Fed stopped publishing it) we notice that M3 increased by only $194 billion in the first quarter (less than the increase in mortgage debt) and that since April there has been a decline in M3.
Whether this is just a seasonal effect is not clear at this stage, but it does seem that money supply growth has slowed down. I find it very amusing that Bernanke is concerned about rising inflation when M3 has declined by 1.15% in the past month (a monetary deflation).
Going forward, I see US economic growth as anaemic at best, spilling over into other markets and reducing demand for commodities such as base metals. That's why I am not bullish on base metals.
It appears that higher interest rates have already started having an effect on the growth in money supply. That could seriously hurt perceived economic growth, especially when cash-out house refinancings abate. Bernanke can of course fix that by "printing money" - monetizing the US Federal Government's debt.
Monetizing the debt would increase the money supply and reduce the outstanding debt, keeping interest rates in check at the same time. The risk with debt monetization is that fractional banking can cause a dramatic expansion of money supply and so debt monetization has to be administered carefully.
Further confusion is created by the Fed, on the one hand, calling for higher interest rates, which boost the US dollar exchange rate, and the Treasury on the other hand calling for a lower US dollar exchange rate to combat the growing US trade deficit. You may have noticed how metals prices slumped this week on the back of a rising US dollar fueled by Bernanke's talk of higher interest rates.
More confusion will come when the dollar starts to fall in the face of rising interest rates (see: https://www.paulvaneeden.com/displayArticle.php?articleId=101) and that is when gold will truly shine. When that happens we could very well see the gold price rise while other metals prices fall since gold, unlike the other metals, is not a commodity.
In the meantime we are back to the same environment we were in for most of 2004 and part of 2005 when rising interest rates buoyed the US dollar exchange rate and kept a lid on the gold price. This time, however, because there was so much hot, speculative money in metals, we are experiencing a correction instead.
I have no idea how long the correction will last or how much the gold price will drop, so for the time being I am sitting on the sidelines.
First published on Kitco.com (www.kitco.com)
By Paul van Eeden
Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com). If you would like to read more from Paul, you can sign up to get his weekly commentary at https://www.paulvaneeden.com/commentary.php.
And if you want to know more about investing in gold, read the report below:
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