Inflation, Deflation And Gold

Let's dub the yield spread between these two notes the annualized inflation gauge, or AIG, not to be confused with the insurer of the same name. The AIG has been making a series of lower highs since early 2000, which is consistent with disinflation. Its present reading of 1.46% annually until 2010 is neither deflationary nor lower than the readings below 1.25% seen in the fall of 2001 or between October 2002 and January 2003.

A Divergence in Expectations

Source: Bloomberg

The AIG as a percentage of the conventional Treasury yield rose fairly rapidly going into the war with Iraq, fell once the shooting war stopped, and has proceeded to rise once more as the Federal Reserve has promised to fight deflation. The TIPS market appears to be finding as credible the Fed's promise to reflate if necessary.

Is expected inflation greater than the cost of holding gold? We can compare the AIG to the annualized repurchase rate. This measure had been negative throughout 2000 and then started to jump toward 0% once the Fed's rate-cut campaign began in January 2001. The measure hovered near the 0% line until the start of 2003. It peaked near 0.80% just before the start of the war and has started to move back toward zero. Given the leading relationship of this measure to the price of gold itself, we would have to conclude that expected inflation exceeding holding costs would support future gold prices.

Gold and Inflationary Expectations

Source: Bloomberg

The Dollar Connection

The dollar's present weakness doesn't stem from any misstatements by Treasury Secretary Snow as much as the Federal Reserve's aggressive rate-cutting policy -- one the bond market finds credible. The inverse relationship between the dollar and the dollar price of gold is strong and historically demonstrable. We have to conclude that if monetary policy continues to be loose and this looseness is not matched by other central banks, the dollar will continue to weaken and take gold higher.