Last week, I got several calls asking me how U.S. tax reform will impact the price of gold. If you can answer this question, you might be able to answer how tax reform will impact other assets. Let me explain.
If you were to analyze the impact of any tax changes on any asset, you have two sets of dynamics to consider: those of the tax reform and those of the asset. What makes the comparison to gold unique is that gold is, if I may call it such, the purest of all assets because it doesn’t change. It is the world around it that changes.
Monetary policy affects nominal prices, whereas fiscal policy affects real prices. That is, printing money might affect the price level, but fiscal policy affects where money gets allocated, and what investments take place. I would like to caution that not everyone agrees, especially with regard to monetary policy, but even if you do not fully agree, bear with me, as a simplified model might help in understanding price dynamics.
When held in a vault (rather than leased out), gold doesn’t generate cash flow. Investors have the choice of investing in a so-called productive asset that generates cash flow; or to park it in something unproductive, such as a hundred-dollar bill in your pocket; or gold. While there’s a convenience factor to the hundred-dollar bill to use for purchases, most would agree depositing the cash in an interest-bearing deposit may be worth the risk. There’s the risk of the default of the counter-party. For bank deposits, FDIC insurance tends to mitigate the risk; and for Treasury Bills or Treasury bonds, there is the full faith of the U.S. government that the principal will be paid back. Yet Treasuries aren’t entirely risk free: the longer you commit your money for, the more interest rate risk you bear (the market value of Treasuries tends to fluctuate the further out the maturity even if the principal is not at risk); and while the US government guarantees to pay back the principal value of its debt, it doesn’t guarantee it will have the same purchasing power at maturity. The chart below shows the purchasing power of the U.S. dollar since December 1970, that is, the purchasing power of your hundred-dollar bill when sitting in your pocket:
This illustrates why the price of gold has appreciated: at the end of 1970, an ounce of gold cost less than $40; currently, it costs over $1,200 an ounce. The gold never changed, but the purchasing power of the dollar has eroded. Indeed, since 1970, the price of gold has appreciated substantially more than the purchasing power of the dollar has declined, suggesting the price of gold is influenced by more than merely the consumer price index.
In my assessment, a key driver of the price of gold is the real rate of return available on other investments. The benchmark for these “other” investments for U.S. dollar based investors is the so-called risk-free investment: Treasuries. Most people don’t walk around with hundred-dollar bills in their pocket, they make a conscious decision how to allocate their money. If they get compensated more for holding Treasuries, the price of gold may suffer (again: because gold is the constant here).