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The end of the second great gold rally

The recent 12-year bull market in gold has come to an end. Gold today is 22% below its 2011 high, but it is still 480% above its 2001 low. This could be a wild ride.

The first great gold rally occurred in the 1970s, sparked by Nixon's decision to abandon the dollar's link to gold. The Fed had been failing to tighten policy since the mid-1960s, despite continual outflows of gold which were symptomatic of declining dollar demand and rising dollar supply—in short, dollars were in excess supply. Set free, gold rose from $35/oz. to a peak of $850 in January 1980, for a spectacular gain of over 2,330%, and the excess of dollars combined with loss of confidence in the dollar fueled a surge of inflation. That incredible gold rally was brought to an end by Fed chairman Paul Volcker, who in 1979 decided to slam on the monetary brakes in order to bring inflation under control. From its peak in early 1980, gold proceeded to fall for the next 21 years. 

The chart above converts the nominal price of gold, shown in the first chart, into an inflation-adjusted or constant dollar price. This also highlights how significant the big moves in gold were, and how well they corresponded to sea-changes in monetary policy. The big decline in gold from 1980 through 2000 coincided with generally tight monetary policy that brought inflation down from double digits to only 2%.

The second great gold rally began in 2001, around the time the Fed realized that it had been too tight for too long and began reducing the Fed funds rate target from 6.5% to 1.75% over the course of that year. The PCE deflator fell at a -0.4% annual pace in the second half of 2001, which was the first time it had ever visited deflationary levels—proof that the Fed had been too tight. As the Fed embraced easy money, gold rose from a low of $256 in early April 2001 to a high of $1900 in September 2011, for a gain of 642%. In real terms, gold reached almost the same levels it had in early 1980.

The latest gold rally is now over, having fallen more than 20% from its all-time nominal high. Many will speculate about its origins and its recent demise, but for me it is fairly straightforward. Gold rose because it had been suppressed by 21 years of tight monetary policy which ended in 2002. Gold rose because the market began to sense that the Fed was too easy—that lowering the funds rate target to 1% and keeping it there from mid-2003 to mid-2004 was excessive ease—and that it was an inflationary mistake. And indeed it was: housing prices soared from 2002 through 2006; commodity prices soared from late 2001 through 2008; and the CPI registered a 5.5% increase in the 12 months ended July 2008. After a brief decline in 2008, when the financial crisis caused a surge in dollar demand that the Fed was slow to respond to, gold resumed its upward climb. Commodities also suffered in 2008, but even more so than gold because a the global recession destroyed demand. Like gold, commodities then resumed their rally from 2009 through early 2011. Commodities peaked in April 2011, and gold peaked shortly thereafter, in August 2011.

As the chart above suggests, gold overshot commodities prices by a significant amount over the past five years. Speculative fever, as expressed by numerous analysts and pundits who called for gold to rise to $15,000, $20,000, and even $46,000, could be one reason. The Fed's quantitative easing programs plumbed uncharted depths and caused any number of people, myself included, to worry that the result could be a lot of inflation and perhaps even a collapse of the dollar. Indeed, there was no shortage of reasons for why gold rose as much as it did. Most of the world's major central banks (with the notable exception of the Bank of Japan) became ultra-accomodative in the wake of the global financial crisis and recession. The Eurozone sovereign debt crisis that erupted in 2010 and 2011 threatened the dissolution of the euro, which by then had become one of the world's most important currencies. But one after one, the fears—of hyperinflation, a dollar collapse, or a euro collapse—fell by the wayside, and now the Fed is talking seriously about ending QE3 within a matter of months. 

In a bizarre twist, the Japanese central bank, which had been doggedly pursuing a mildly deflationary monetary policy for decades, is now committed to a reflationary policy. With the recent sharp weakening of the yen, gold in yen terms has finally reached the same level as it did in early 1980 in nominal terms, though it is still about 30% below the inflation-adjusted levels of early 1980.  

Looking ahead, as a first approximation I think gold could fall to $1000 or even less, as it realigns with other commodity prices (see second chart above). Gold bugs: look out below! There are undoubtedly a lot of speculative purchases that may need to be unwound in coming years.

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