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`Inflation, interest rates driving gold'

G. Chandrashekhar

Mumbai , Dec. 24

GOLD makes the world go around; but what makes gold go around?

Commodities guru Mr Larry Williams has the answer. According to the ace trader, regardless of what you think or think you know, gold is driven by one of the three forces, namely supply and demand for industrial or commercial use; fears of inflation or lack thereof; and interest rate differentials.

Gold is widely believed to be a safe-haven investment in times of uncertainty, economic depression and stock market crashes. The expert, who made all his millions on stock and commodity markets, firmly believes it is a myth that gold will rally during depressions and market crashes.

Based on historical price data since 1920, Mr Williams shows depression set upon the world in 1929-1932; and yet, gold and even gold stocks did not take off the upside until after the depression was over. The yellow metal was stable until inflation grew throughout the world in the 1970s. It is conceivable sudden sharp spike in crude oil prices contributed to inflation.

So, the first rule of investing in gold, according to Mr Williams, is that the metal rallies in inflationary environment. Even commonsense suggests that in a crash everyone is too scared to buy anything, while in an inflationary environment, people realise they need to protect their money that is losing value.

It is during times of inflation that people buy real assets, hard assets such as gold, real estate and even art or collectibles, along with stocks, the expert asserts, adding that stocks and gold can rally at the same time for the same reason.

To make his point, Mr Williams refers to the largest bull market ever in gold, in 1980. Both stocks and gold made a new high in the year. In an inflationary economy, money drives and chases all assets, and so inflation and gold are hand-in-glove, the expert declares. Interest rates are also one of the key drivers of gold market rallies and declines. Again, based on data from 1987 till 2003, Mr Williams demonstrates how gold and interest rates move together.

Both are positively correlated, whether in rallies or declines. So, the second golden rule for gold is: follow the interest rates.

Making an interesting observation, Mr Williams says: "When Alan Greenspan took over at the Fed in 1987, gold rallied, just as it did when the new head of the Fed was appointed in 2005. Quite strong parallel here. The 1987 gold rally lasted 3 months making new highs and then tanking... 2005 looks similar".

Inflation plays a larger role in interest rate determination and needs to be factored into the equation to see what's really going on in the economy. To do this one must examine the differential between interest rate and inflation.

Typically, to arrive at true yield, inflation is subtracted from interest rate. If interest rate is 8.5 per cent and inflation is 3.2 per cent, the real cost or spread is 5.3 per cent which suggests that borrowing is relatively more expensive.

On the other hand, if interest rate is at 18.5 per cent and inflation is 17 per cent, the true cost of money is only 1.5 per cent and is a bargain.

When cost of money is high, gold goes down and when it is cheap, gold rallies. According to Mr Williams, the logic behind this is that investors, institutions and governments are encouraged to take their money out of, say US treasury bills, when yield is having a difficulty in keeping up with inflation.

Indeed, it could be argued that gold shot up in the 1970s not merely because inflation was `high', but partly because inflation was `higher' than the yield on T-bills.

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