Our plot begins this past July when Dow Chemical announced that it would no longer absorb increasing energy prices.  Polyethylene resin price increases were announced in July and again in September. Subsequently, Clorox announced a 10% increase for its Glad bags which are made of polyethylene. In other words, intermediate and finished producer price increases were being passed on to the consumer.  “Effective January 1, 2006, the Company is implementing price increases ranging from 5 to 10% on about 40% of its portfolio, including Glad trash bags, Match Light charcoal, and Brita pitchers and filters” said Clorox.  Even Tennessee Williams, author of the dark and foreboding screenplay that is the same as our title would find nothing exciting in this plot other than a change in perception by one group of investors: gold bugs. From January 2004 through July 2005 gold had been trading in a range of $420-$440 per ounce. After mid-July when it was selling at around 425 per ounce it moved sharply upward to 535 in mid-December, or about 26%.  (Since that time gold has retreated to under 500.) (See Chart 1).

When President Nixon was forced to officially suspend the international convertibility of the dollar (into gold), the dollar became a floating currency and was essentially devalued.  Gold then more than doubled over the next two years as traders attempted to find equilibrium prices. As an investment, however, gold is not all that attractive. It pays no dividend, has no earnings, and no book value. It is a commodity, but as a “precious metal” its scarcity made it suitable for use as a currency.  When prices rise (inflation), the amount of currency (i.e. gold) needed to buy an item rises as well (or the price per ounce of gold must rise.) In reality however, gold is a hedge against the “depreciation in a currency’s value, both internally (i.e. inflation) and externally (against all other currencies).”1 Thus gold bulls have often referred to gold as a “storehouse of value”. We can best track how gold has been priced by dividing it by a common measure of inflation, the consumer price index-core, i.e. excluding energy and food (CPI-C). This is the same inflation rate that bond analysts use to compute “real” (e.g. inflation adjusted) bond yields. Chart 2 shows the price of gold divided by CPI-C. In fact gold has not been a great storehouse of value.  The compound annual return from owning one year Treasury notes since 1974 would have been twice that of owning gold.  More important than the debate about owning gold is the discussion of what this most recent increase in gold’s price means for the economy and other investment vehicles.

Like all commodities, when there are more buyers than sellers, the price will rise (regardless of the underlying fundamentals). There are many reasons given for the increased demand for gold. First and foremost is the incremental demand from the burgeoning middle class in India and China. Then there is the new ability to buy gold in the form of an exchange traded fund which has added considerable domestic demand for the yellow metal. Lastly, there has been a reduction in central bank sales of gold reserves which limits the supply of gold coming to market.

Although the price of gold is often referred to as an inflation hedge, it does a much better job of predicting short term interest rates. Chart 3 shows the relationship between the price of gold (divided by the CPI-C) and the yield on one-year Treasury notes. Over three decades the average lead-time of gold over short term interest rates has been 12 months. Over the last two decades, however, the typical lead-time of gold has been 20 months. (See Chart 4). Using a simple linear regression model, current prices for gold imply a yield on the one-year Treasury note of 5.47% by August of 2007 compared with 4.32% currently.

As would be expected, a very good relationship can be found between gold and the G-5 (France, Germany, Japan, the United Kingdom, and the United States), trade weighted dollar over the last two decades. (See Chart 5.)  At current levels the gold market is telling us that either the dollar exchange rate is going to reinstate its downtrend (which began in 2002) or that the Federal Reserve Board will continue raising rates into 2007.  (Both could happen if the Fed increases rates more slowly than the European Central Bank.)

Using the last two decades as a statistical base it appears that not only is gold a good predictor of the trade weighted dollar (leading by 12 months) but also of capacity utilization (by 17 months).  (See Chart 6.)  Both of these statistics can be construed as leading indicators of inflation.  Capacity utilization leads core producer price indexes by about 8 months.  If the dollar were to decline again (adding import price inflation pressure) and capacity utilization were to increase to 82%-83% a year from now, I believe the Fed would once again take pre-emptive steps and reinstitute their “inflation fight”.  Nonetheless, gold does not have a very consistent record of forecasting core inflation (See Chart 7).

Conversely, the bond market has had an excellent record of keeping aligned with CPI-C rate of change and provides about an 8 month lead time. (Chart 8).  Presently, however, the ten- year Treasury bond is yielding 4.45% and is implying a core inflation rate of 1.76% eight months from now.  That would be a retreat from the 2.1% recorded over the last twelve months. On the other hand, the inflation implied by subtracting the ten-year Treasury Inflation Protected Security (TIPS) yield from the nominal ten-year yield is 2.34%.  Our own estimate of core CPI for 2006 is 2.5%. If we use that forecast in our bond model, we envision significantly higher yields than currently exist. There might be a greater chance of this occurring if the dollar exchange rate begins to decline (i.e. a weakening dollar) leading foreign buyers to circulate currency reserves into investments other than dollar denominated fixed income. And maybe, after all, this is what the rise in the price of gold is telling us. We’ll only know if the higher price for Glad trash bags “sticks” at the retail level!

S&P: 1267.3                                                                                     John K. Dolan 
Gold: 501.4
December 22, 2005