Inflation, Deflation And Gold

A Floating Gold Standard

Source: Bloomberg

Give Lease A Chance

The demand to borrow gold can be measured by the lease rate, the difference between LIBOR and the gold swap rate. This measure works much like a short interest ratio in stocks: Heavy demand to borrow metal for short sales creates the potential for a future short squeeze. Jumps in the lease rate frequently preceded jumps, albeit short-lived ones, in the price of gold itself.

No Interest in Shorting Gold

Source: Bloomberg

Lease rates expressed as a percentage of LIBOR have been tracking downward since the spring of 2001, the point at which stocks began to ignore the Fed's rate-cutting campaign. Gold prices have continued to track higher, which suggests little speculative interest in selling gold at the recent higher prices. While some could construe this as a negative indicator, such behavior commonly is found at the start of long-term bull markets.

Never Certain

While all three measures appear to support the prospects of higher gold prices, there are no sure things. An aggressive round of rate-cutting globally could support the dollar, and if this is accompanied by prolonged price weakness, gold could fall and fall hard. In addition, the bond and gold markets could be deceived by faith in the Federal Reserve much the way the stock market has been over the past three years.

But gold can acquire a security value in a deflationary period as returns on other assets become so small and as faith in governments so shaken as to make gold an attractive alternative. Should this very negative environment emerge, gold could have the same option straddle value as do TIPS. Now there would be an interesting portfolio to bet against long-term price stability: gold plus TIPS.