October 20, 2009

Economics Group

Special Commentary
Jay Bryson, Global Economist
jay.bryson@wachovia.com ● 704-383-3518
Anika R. Khan, Economist
anika.khan@wachovia.com ● 704-715-0575
Yasmine Kamaruddin, Economic Analyst
yasmine.kamaruddin@wachovia.com ● 704-374-2992

What Is Gold Telling Us?

Executive Summary
Gold prices have surged in recent months, which some observers claim is a clear warning that
inflation will soon turn sharply higher as it did in the late 1970s. However, other forward-looking
market-based inflation indicators do not support this hypothesis. Inflation indicators such as
bond yields, consumer expectations and TIPS spreads have been running at fairly depressed
levels, which suggest inflation will likely remain benign. 1 If the spike in gold prices is not a sign of
looming inflation, why are gold prices at a record high?
It appears that foreign central banks may be playing a role in driving gold prices higher. After two
decades of reducing their holdings of gold, central bank purchases of the precious metal set a
record in July and anecdotal evidence suggests they have continued to buy more recently. In
addition, the increase in futures contracts outstanding indicates that speculative activity is also
picking up.
Does the apparent attempt of foreign central banks to build up their holdings of gold indicate that
they have “lost confidence” in the dollar? Probably not, at least not yet. Foreign central banks
appear to be diversifying on a flow basis only because they remain net buyers of U.S. Treasury
securities. If foreign central banks had indeed “lost confidence” in the greenback, we think they
would be reducing their holdings of Treasury securities. However, indications that the United
States is not serious about addressing its long-run fiscal challenges could eventually lead foreign
central banks to reassess their willingness to continue financing U.S. government obligations.
Gold Prices as a Harbinger of Inflation
Many recall the gold price spikes of the early 1970s and early 1980s that heralded double-digit Gold prices surged
inflation months in advance. Indeed, the doubling of gold prices between late 1972 and mid-1973 in the late 1970s as
was followed by a sharp increase in consumer price inflation (Figure 1). That episode in the early CPI inflation shot
1970s was simply a warm-up act for the early 1980s when gold prices surged to the unheard of higher.
price of $650/ounce in January 1980. By spring of that year, CPI inflation was running near
15 percent. Today, the price of gold has been trending higher for a year, and currently exceeds
$1000/ounce. Does the recent moonshot in gold prices herald another decade of runaway
inflation?
Between the early 1970s through the late 1990s, gold prices and the rate of inflation followed a
relatively predictable path. A persistent upward trend in gold prices became a fairly reliable
harbinger of high inflation. As such, investors seeking to hedge against inflation flocked to gold,
pushing up the price even higher.
Before we all cash in our monetary savings for prized art objects, which were used as an inflation
hedge in the 1970s, let’s put the current increase in gold prices into perspective. Although the
price of gold is currently at a record level, its price changed more quickly in the late 1970s than it

1 The TIPS spread is the difference between the yield on a Treasury security and the yield on the Treasury Inflation-
Protected Security of comparable maturity. Therefore, the spread measures the difference between a nominal yield and a
real yield, and can thus be interpreted as a measure on inflation expectations.

This report is available on wellsfargo.com/research and on Bloomberg WFEC

 What Is Gold Telling Us? WELLS FARGO SECURITIES, LLC
October 20, 2009 ECONOMICS GROUP

has at present. Over the past 12 months the price of gold has risen about 50 percent, a sizeable
increase but well short of the near trebling in price that occurred between January 1979 and
January 1980. In real terms, the price of gold is about 50 percent below the peak that it reached
in January 1980 (Figure 2). Therefore, the inflationary signal that today’s increase in gold prices
may be sending does not appear to be as strident as the warning sent three decades ago.

Figure 1 Figure 2
CPI vs. Lagged Gold Prices Real vs. Nominal Price of Gold
Year-over-Year Percent Change, Dollar per Ounce Index, January 1980 = 100
25% $1,200 120 $1,200
CPI, Year-over-Year Percent Change: Sep @ -1.3% Real Gold Prices: Sep @ 56 (Left Axis)
Gold Spot Price, 1-Year Lag: Oct @ $1,066.02 per Ounce 110 Gold Spot Price: Oct @ $1,066.02 per Ounce (Right Axis) $1,100

20% $1,000 100 $1,000

90 $900

15% $800 80 * Real price of gold delfated using CPI $800

70 $700

10% $600 60 $600

50 $500

5% $400 40 $400

30 $300

0% $200 20 $200

10 $100

-5% $0 0 $0
1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

Source: U.S. Department of Labor, Bloomberg LP and Wells Fargo Securities, LLC
If inflation is a Moreover, we are not convinced that the current run-up in the price of gold is indeed associated
concern, then why with concerns about rising inflation, because other early-warning signals of inflation are
are Treasury yields quiescent at present. Consider Treasury bond yields. The high inflation rates of the early 1980s
so low? and expectations that inflation would remain elevated led to double-digit yields on 10-year U.S.
Treasury securities (Figure 3). Today, however, the yield on the 10-year U.S. Treasury security is
comfortably below 4 percent. Would investors really be concerned about runaway inflation if they
are willing to lend money to the U.S. Treasury for 10 years at less than 4 percent per annum?
Moreover, the yield spread between the nominal 10-year bond and the inflation-protected 10 year
bond, the so-called TIPS spread, is less than 2 percent at present.
The Fed announced in March 2009 that it would buy $300 billion worth of Treasury securities to
help hold down long-term interest rates. Couldn’t the Fed’s extraordinary purchase program
artificially reduce Treasury yields and render them useless as an inflation signal? In the absence
of the Fed’s purchases, wouldn’t Treasury yields be higher and investor concerns about inflation
be more visible?
Maybe, but the Fed is near the end of its purchase program. It seems that Treasury yields would
have already reacted to the well-publicized news that the Fed plans to wrap up its program by the
end of October 2009. Moreover, the Fed’s total purchases represent only 4 percent of the
$7 trillion worth of marketable Treasury securities outstanding. It does not seem likely that the
Fed’s actions would be able to hold down yields if investors really feared an inflationary outbreak.
Consumers’ Moreover, other inflation indicators are not flashing red at present. There is a question in the
inflation University of Michigan’s survey of consumer attitudes that measures inflation expectations over
expectations the next five years. This measure of inflation expectation rose to nearly 10 percent in the early
remain well 1980s, but it has remained remarkably steady over the past decade or so suggesting that
contained. consumers do not seem to be too worried about inflation at present (Figure 4). Therefore, the
hypothesis that the sharp increase in gold prices recently foretells an episode of rapidly rising
inflation does not appear to be supported by other measures of inflation expectations.
Another plausible idea is that the rise in gold prices is due to an increase in risk aversion. In the
past, investors have flocked to the safety of gold when they have become spooked. If risk aversion
were rising, however, then why have the prices of equities, whose uncertain cash flow

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What Is Gold Telling Us? WELLS FARGO SECURITIES, LLC
October 20, 2009 ECONOMICS GROUP

characteristics make them among the riskiest of financial assets, increased so much recently? 2
The fall in the VIX index, which measures stock market volatility, and the narrowing of credit
spreads also indicate that risk aversion is declining, not increasing.

Figure 3 Figure 4
10-Year Treasury Yield vs. TIPS Spread Inflation Expectations in Five Years
Percent University of Michigan
20% 20% 10% 10%
US 10-Year Government Bond: Sep @ 3.31%
18% TIPS Spread: Sep @ 1.77% 18% 9% 9%

16% TIPS spread = 10 Year Govt. Bond Yield - 16% 8% 8%

10 Year Inflation-Protected Government
Bond Yield
14% 14% 7% 7%

12% 12% 6% 6%

10% 10% 5% 5%

8% 8% 4% 4%

6% 6% 3% 3%

4% 4% 2% 2%

2% 2% 1% 1%
Inflation Expectations in 5 Years: Oct @ 2.9%
0% 0% 0% 0%
1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

Source: Federal Reserve Board, University of Michigan and Wells Fargo Securities, LLC
Some Central Banks Are Switching into Gold
If expectations of rising inflation and increasing risk aversion do not appear to be good Central banks
explanations for the recent run-up in the price of gold, then what explains its increase? We purchased a record
believe that central banks may be part of the story. The price of gold fell to roughly $900/ounce amount of gold in
in early July, but it has risen essentially non-stop in subsequent weeks. Interestingly, gold July.
purchases by central banks increased by a record amount in July (Figure 5). Although “hard” data
for central bank holdings of gold in August, September and the first few weeks of October are not
yet readily available, anecdotal evidence suggests that central banks have continued to purchase
gold. For example, a recent Wall Street Journal article noted that the Taiwanese central bank will
likely increase the amount of gold in its foreign-exchange reserves. 3
Why would central banks have an interest in buying gold? Central banks have increased their Foreign central
foreign exchange holding from about $2 trillion at the beginning of the decade to roughly banks appear to be
$7 trillion at present, and the U.S. dollar comprises about two-thirds of that total. How many diversifying away
more dollar assets do foreign central banks need? Although foreign central banks continue to buy from the dollar on
U.S. Treasury securities—they purchased $53 billion in the 12 months through August 2009—the a flow basis.
pace of purchases has slowed over the past year or so. Foreign central banks are not dumping
U.S. assets, but they appear to be diversifying their purchases on a flow basis. Although central
bank holdings of gold have trended lower for the past two decades, foreign central banks may be
buying gold again as a way to diversify their portfolios and their purchases appear to be
contributing to the increase in the price of the precious metal.
Speculators May Be Piling On
It also appears that speculators have thrown their hat in the ring and are helping to push gold
prices up even higher. One measure of speculative activity is the number of futures contracts
outstanding, so-called “open interest”, on the COMEX exchange. Future contracts allow investors
to realize financial gains through price changes without taking physical possession of a
commodity. The price of gold and the amount of open interest have been trending higher over the
past few years (Figure 6). Since early September open interest has increased by 165,000
contracts, the largest six-week rise in about 10 years. Although commercial accounts (i.e., end
users of gold) may be increasing the number of future contracts they buy to hedge against further

2The S&P 500 index is up more than 60 percent relative to its bottom in March 2009.
3Perris Lee Choon Siong, “Taiwan Ctrl Bank Gov: Can Study Increasing Gold in FX Reserves”, the Wall Street Journal,
Oct. 13, 2009

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 What Is Gold Telling Us? WELLS FARGO SECURITIES, LLC
October 20, 2009 ECONOMICS GROUP

large price increases, we suspect that non-commercial accounts (i.e., speculators) are also behind
the recent increases in open interest and the price of gold.

Figure 5 Figure 6
Official Holdings of Gold Gold: Total Open Interest Contracts vs. Spot Price
In Millions of Troy Ounces In Thousand, Dollars per Ounce
1,200 1,200 700 $1,100

$1,000
600
1,150 1,150 $900

500 $800
1,100 1,100
$700
400
$600
1,050 1,050
$500
300
$400
1,000 1,000
200 $300

950 950 $200

100
Total Open Interest/Combined Contracts: Oct @ 671,445 (Left Axis) $100
Official Holdings of Gold: Jul @ 968 Million Troy Ounces Gold Spot Price: Oct @ $1,066.02 per Ounce (Right Axis)
900 900 0 $0
1989 1993 1997 2001 2005 2009 1996 2000 2004 2008

Source: Bloomberg LP, International Monetary Fund and Wells Fargo Securities, LLC
Conclusions
Some observers have interpreted the record rise in the price of gold recently as a warning that the
United States is on the cusp of another inflationary period à la the late 1970s/early 1980s.
Unprecedented amounts of liquidity that the Federal Reserve has pumped into the banking
system and record budget deficits of the federal government also seem to support the notion that
years of crippling inflation may be just around the corner. However, other early warning
indicators of inflation, such as yields on U.S. Treasury securities and measures of consumer
inflation expectations, do not support the hypothesis that investors are universally concerned
about a period of runaway inflation.
Rather, the recent rise in the price of gold appears to be related, at least in part, to attempts by
foreign central banks to diversify their reserve holdings on a flow basis. After years of reducing
their holdings of gold, foreign central banks bought a record amount of the precious metal in July
and anecdotal evidence suggests that their net purchases have continued over the past few
months. Speculators appear to be jumping on the pile as well, which also may be helping to push
up gold prices. Although it is impossible to determine how much central banks wish to increase
their holdings of gold, the big decline in their gold portfolios that has occurred over the past two
decades suggests that they have scope to continue buying gold for some time.
Foreign central Interest by foreign central banks to increase their gold holdings begs a more fundamental
banks have not question. Have they lost confidence in the dollar? Probably not, at least not yet. As noted above,
“lost confidence” in foreign central banks have purchased $53 billion worth of Treasury securities over the past 12
the dollar, at least months. Although the pace of purchases has slowed from its rate of a year or so ago, we think
not yet. foreign central banks would have become outright net sellers of Treasury securities if they had
“lost confidence” in the greenback. Foreign central banks are not dumping dollars, but they
appear to be diversifying away from the greenback on a flow basis.
As we argue in a recent report, however, indications that the United States is not serious about
addressing its long-run fiscal challenges could eventually lead foreign investors and central banks
to reassess their willingness to continue financing U.S. government obligations. 4 Although there
is little evidence to date to suggest that that point has been reached, the price of gold could
skyrocket if foreign governments do indeed lose confidence in the dollar.

4 See “What’s Wrong With the Dollar?” (September 24, 2009), which is posted at www.wachovia.com/economics.

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Wells Fargo Securities, LLC Economics Group

Diane Schumaker-Krieg Global Head of Research (704) 715-8437 diane.schumaker@wachovia.com

& Economics (212) 214-5070

John E. Silvia, Ph.D. Chief Economist (704) 374-7034 john.silvia@wachovia.com

Mark Vitner Senior Economist (704) 383-5635 mark.vitner@wachovia.com
Jay Bryson, Ph.D. Global Economist (704) 383-3518 jay.bryson@wachovia.com
Scott Anderson, Ph.D. Senior Economist (612) 667-9281 scott.a.anderson@wellsfargo.com
Eugenio Aleman, Ph.D. Senior Economist (612) 667- 0168 eugenio.j.aleman@wellsfargo.com
Sam Bullard Economist (704) 383-7372 sam.bullard@wachovia.com
Anika Khan Economist (704) 715-0575 anika.khan@wachovia.com
Azhar Iqbal Econometrician (704) 383-6805 azhar.iqbal@wachovia.com
Adam G. York Economist (704) 715-9660 adam.york@wachovia.com
Ed Kashmarek Economist (612) 667-0479 ed.kashmarek@wellsfargo.com
Tim Quinlan Economic Analyst (704) 374-4407 tim.quinlan@wachovia.com
Kim Whelan Economic Analyst (704) 715-8457 kim.whelan@wachovia.com
Yasmine Kamaruddin Economic Analyst (704) 374-2992 yasmine.kamaruddin@wachovia.com

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