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Has gold peaked or is the bull run still underway?

16 Apr

Commentators love simplicity.  Most news sources blame gold’s precipitous fall on the expectation that the Fed will tighten monetary policy soon. If that’s the case, why have bond yields been so muted?

It doesn’t add up.

QE has been supporting numerous assets, the main one being government bonds which have been the main beneficiaries of the newly created dollars. If there was any real risk that the Fed really would stop printing, government bonds would have felt the impact immediately with yields rising sharply.

Given that 10 year Treasury yields actually fell by 4 basis points yesterday to 1.68% there is very little evidence that QE is going away any time soon.

There are a number of reasons for this. The economy continues to stall and unemployment remains persistently high. Until key economic indicators start to improve meaningfully, the Fed has little reason to stop. Ironically, the drop in food and energy prices actually takes pressure off the Fed to end QE soon.

So why has gold fallen so steeply, so fast? Data points to the closing of speculative longs rather than any significant change in demand for gold use in jewellery, which accounts for approx. 45% of gold demand.

Will it continue to fall? The risks appear to point to the upside:

QE is not going away soon (Japan has vowed to double its monetary base over the next two years) and the cost of capital remains at historically depressed levels.
At the current price, producers fail to make a profit on gold mining which should lead to a fall in production.
Central bankers continue to buy (with the possible exception of Cyprus in the short term).
Demand for jewellery in Asia and other emerging markets continues to rise.
Global currency debasement will ultimately lead to inflation.

Gold is a volatile asset but its long term fundamentals remain intact. The canary in the coalmine must be government bonds, so worth keeping yields in check.

Whatever the reason, gold is no Bitcoin!

Does money printing really affect the price of gold?

28 Feb

Yes. Economic theory would suggest so and the proof appears to back the theory.

The quantity theory of money asserts that changes in the quantity of money cause a proportional change in the price level, expressed as:

MV = PT

Where M is money, V is velocity, P is price level and T is trade. PT combined would therefore  = GDP.

Economists are all fighting over whether QE will ultimately lead to inflation. I believe it will but it is fair to say that a huge number of factors affect the CPI, and it isn’t as simple as it sounds.

So let’s simplify it. Let’s just look at whether QE could lead to gold price inflation. Given both gold and the dollar are units of currency, one can simplify the equation to M = P or 1 unit of USD = 1 unit of Gold. Given that gold can’t be printed, a doubling of ‘M’, for example, should lead to a rise in P. i.e. P = 2M or 1 unit of gold now equals 2 USDs.

Has gold been rising with money supply?

The chart below shows the US Monetary Base overlaid by the price of gold going back to 1960. Given the dollar was taken off the gold standard in 1968, one would expect some deviation between the two series, but the correlation is still very striking.
US monetary base vs Gold
(Source: Bloomberg)

Another interesting chart looks at the size of the Fed’s balance sheet. The white line shows the staggering expansion of the Federal Reserve’s balance sheet which has expanded by US$2.5 trillion since 2007. To put this in context, it took almost 100 years for the Fed to build its balance sheet to US$0.9 trillion and it then almost tripled this in the last four years.

However, if we look at the Fed’s balance sheet in gold terms (orange line) we can see that it hasn’t actually expanded by anywhere near as much. In fact it’s about the same size as it was back in 1997!

Fed Balance sheet price in gold
(Source: Bloomberg)

Unemployment remains high (U6 unemployment remains at 14.4%) and the economy is yet to recover. No, we haven’t even mentioned sequestration yet. The Fed will not be stopping QE any time soon and gold’s upwards trajectory is therefore unlikely to deviate too far from the trail of the US’s highly expansive monetary base.

Gold as an inflation hedge

30 Jan

gold bars

Gold bullion as a hedge against inflation

The Central banks of the world’s biggest economies are all in a ‘battle’ to devalue their currencies. By ‘printing’ enormous quantities of currency through quantitative easing, central banks are aiming to debase the value of their currency and therefore increase the competitiveness of their industry overseas. This should drive (a little – they hope) inflation which should motivate consumers to spend and invest. That is the theory.

In practice, however, this is a very risky attempt to manipulate the value of fiat currencies, which could lead to a severe currency and inflationary crisis and consumers lose faith in the value of paper money. In this environment gold could prove to be the ultimate hedge.

Quick Overview

Positives

  • Gold has been a safe store of value in periods of high inflation
  • It has been used as a form of exchange and currency for millennia
  • Gold is easily transported
  • You cannot print it

Negatives

  • Gold does not provide a yield
  • The gold price is volatile and in periods of low or negative inflation it can be subject to severe draw-downs

Let’s take a look at these points in more detail.

1). Gold has been a safe store of value in periods of high inflation

Gold 1970s

There is no denying that gold has fulfilled its role as a store of wealth for the last 2500 years. The gold in an aureus coin of the B.C. Roman Empire would purchase approximately the same quantum of commodities, labour, or fixed property today as it could then. No fiat currency ever introduced, even if all interest paid on it had been re-invested without taxation, has come close to passing that test over any extended period.

In 2011 Warren Buffet gave this – now infamous – view on gold, which has since been adopted as part of the gold bears’ doctrine:

“I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion dollars – that’s probably about a third of the value of all the stocks in the United States. For $7 trillion dollars…you could have all the farmland in the United States, you could have about seven ExxonMobils, and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it
and fondling it occasionally…Call me crazy, but I’ll take the farmland and the ExxonMobils.”

His point is indeed very valid. However, I think Mr. Buffet would struggle to find another asset that, despite decades of inflation (the US dollar has lost 96% of its purchasing power since the creation of the US Federal Reserve in 1913!) could still buy the buy the same, if not more, assets than it could 100 years ago. In other words, gold has fulfilled its role as a secure store of value, as it has done for millennia.

2). It has been used as a form of exchange and currency for millennia

The history of Gold as money in modern coin form spans 2630 years. The earliest known use was in 643 B.C in Lydia (present-day Turkey). Gold was part of a naturally occurring compound known as electrum, which the Lydians used to make coins. By 560 B.C., the Lydians had figured out how to separate the gold from the silver, and so created the first truly gold coin.

Numerous civilizations throughout history have had obsessions with gold. The Roman empire, the Aztecs, the Incas, the Mayas and many others all had a fascination with gold. The Romans were the most successful of these in harnessing its use for trade, but it has always been used for trade or as a powerful display of wealth and social standing.

3). Gold is easily transported

Property and land are real assets that should theoretically retain their purchasing power relatively well over economic cycles. However, one would struggle to carry their property across borders. Due to the heavy nuclei in its atoms which are closely packed, gold is a heavy precious metal and therefore one doesn’t need a huge amount of it to be carrying a very valuable cargo.

The traditional gold bar stored by central banks, weighs 400 troy ounces (438.9 ounces of 12.4kg) and can therefore easily be carried, is worth about $660,000 at today’s gold price.

Moreover, property and land may be seized by governments or creditors should they have debt associated to them, or even taken over by foreign enemies in war. Other real assets such as inflation linked bonds can very quickly have their value eroded by a collapse in the currency of the bond’s denomination.

It is worth noting, however, that governments can make it illegal to ‘hoard’ gold, as happened in the US in 1933. Therefore, storage is a crucial element of owning physical gold bullion. Investors should also note that the safest investment in gold is in physical gold bullion itself as the many forms of derivatives and exchange traded funds that track its price very successfully is normal times, might be ineffective as a form of exchange in extreme events.

4). Gold cannot be printed

Printing dollars vs. Gold Mining
The price of gold is determined by supply and demand. While demand for gold is impossible to predict, one should assume that in times distress, demand for quality assets should rise. Supply of gold, on the other hand, is a little easier to predict given there is a limited quantity of it on our planet and we are restricted by how much we can extract from the earth. It’s supply therefore should remain reasonably constant.

So the theory goes:

Gold is priced in USD
USD supply is increasing substantially through Quantative Easing le while the supply of gold is limited
The USD should therefore fall in value relative to gold. Or in other words, the gold price, in USD, should rise.

Negatives

1). Gold does not provide a yield

While property, stocks and inflation linked bonds can provide a yield through rental income, dividends or interest payments, gold provides no yield.
This is true in most environments, but with today’s ZIRP (zero interest rate policy) world, even yielding assets produce very little income. Some, such as inflation linked bonds, even give a negative yield!

2). The gold price is volatile and in periods of low or negative inflation it can be subject to severe draw-downs

Gold’s 30-day standard deviation over the last 10 years has averaged 10% vs. 12% for global equities. The peak for gold volatility was in October 2008 when it peaked at 56%, although during that period equity volatility peaked at 82%.

The issue with volatile assets is that they can be subject to severe draw-downs and gold is no exception. The worst draw-down ever in gold was between September 1980 and August 1999 when it lost 62%. Had someone bought at the top in 1980 it would have taken them 21 and a half years to recoup their initial nominal investment, see chart below.

Gold recovery period

Most commentators take very extreme views on one specific asset for an all in or out approach. That is definitely the best way to make (or lose!) a lot of money in short periods of time, but for sensible investors the key is to diversify into a number of asset classes and adapt the weighting to these as the economic cycle develops. Gold is not a guarantee for success and will be subject to severe draw-downs again in the future. However, at this juncture in the economic cycle, with uncertainty at every corner and central banks fighting to debase their own currencies, the asymmetry seems to point very much in favour of owning a portion of one’s assets in gold.

Gold as a hedge against Japanese hyperinflation?

23 Jan

With the BoJ entering the Currencies War, how will the Yen perform over the coming months?

Although the Yen has strengthened against most major currencies, the Gold price in Yen has consistently risen over the past 5 years.

Gold in JPY

(Source: Bloomberg)

If expectations of further QE by Japan materialise (very possible with a new ‘government friendly’ governor at the BoJ in April) gold could easily rise substantially.

As Greg Canavan, at the Daily Reckoning Australia, points out, “What’s interesting to think about is what happens if Japan is actually successful and they hit their 2% inflation target? The JGB market, the largest capital market in the world with about 1 quadrillion Yen in bonds outstanding (that’s not a typo), enjoys the lowest interest rates in the world. It costs the Japanese government around 0.75% to borrow for ten years. How they maintain this advantage with a 2% inflation rate is anyone’s guess. Our guess is that they won’t and their interest expense will jump sharply.

And when your interest expense on 1 quadrillion in debt outstanding doubles, it is game over.

The BoJ can’t buy enough bonds to muffle the impact of the jump in expenses. When you have to print just to pay your interest bill, it really is the end of the road. That’s because it’s different from actual debt monetization, which is what they are practicing now. When you monetize debt, you buy an asset from the private sector (usually banks) and create cash in return. That cash takes the form of an increase in bank reserves.

But when you have to print to pay your interest bill, what do you do? The BoJ will have to buy JGBs not from the private sector, but directly from the government itself. When the market sees this happening (and it looks like it will sometime around 2015 based on this latest announcement) then the private market will DUMP that quadrillion Yen hoard onto the BoJ so fast they will barely have time to utter the word hyperinflation.

Which is probably why you saw a rush to take out some insurance in the last few weeks. Gold priced in Yen just broke out to a new high. Not an all-time high though, gold in Yen is yet to break-through its 1980 super-spike peak. But still, the Yen-based gold bull market is alive and well. And as more and more Japanese investors get their heads around the calamity that awaits the JGB market, it could be the most bullish thing for gold yet.”

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