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!

Move aside Bernanke. Bank of Japan blows away expectations with its boosted QE

5 Apr

On April 4th the Bank of Japan announced an enormous shift in policy and the largest monetary injection ever announced by a major Central Bank. The new governor, Haruhiko Kuroda, had been expected to come up against opposition from other policy members who had been tied to the BoJ’s previous philosophy on monetary policy. The reaction was so surprising not only because of the scale of action in itself, but also because of the approval Mr. Kuroda received from all but one of the nine board members.

The flood gates are not just open, they have been blown away.

In order to change the deflationary expectations so ingrained in the Japanese psyche only a major boost in asset and consumer prices would suffice. This is exactly what the BoJ is trying to do. By committing to doubling the monetary base over the next two years from 29% to 55% of GDP (Y135tn to Y270tn) – an increase of a over 1% of GDP per month compared to the Fed’s 0.5% – the BoJ has very dramatically stated that inflation will no longer elude Japan.

The effects to equity, bonds and the Yen should be sizeable. Indeed, we have already seen a sudden drop in the Yen and, more importantly, a dramatic fall in bond yields of longer duration (up to 40 years), where the BoJ is attempting to remove duration risk from the private sector, hence encouraging investment in real assets. Equities should continue to surge as capital flows away from the bond market but investors should be very wary of inflationary expectations. Should bond yields start to rise the great monetary experiment could very easily end in disaster.

Party while the music plays but beware that the endgame for Japan has been brought meaningfully closer than ever before.

Japan economy to grow 2.5% in fiscal 2013. Really???

28 Mar

Japan has unveiled its growth forecast for the fiscal year starting in April, saying the economy is on track to expand 2.5% thanks to fresh stimulus and a recovery in key overseas markets.

Prime Minister Shinzo Abe’s cabinet approved the forecast on Monday morning. The government is trying its very best to convince everyone that its monetray stimulus will lead to economic growth.

But can it succeed? The chart below shows that 2% growth was last achieved back in 1996!

Japan GDP

The latest weakening of the JPY could definitely help, but it would need to remain undervalued for some time before its effects were felt in the real economy.

The chart below shows the JPY’s purchasing power parity vs. the USD.


As can be seen, when Japanese GDP was last above 2% the Yen had been undervalued against the USD for some time. The JPY is reasonably close to fair value currently and would need to be nearer  vs the USD at current PPP to have any meaningful effect on the economy.

While inflationary expectations have consistently risen since the credit crisis in 2008, the chart below showing the 7 year breakeven rate in Japan (a measure of inflationary expectations for the next seven years) shows that little has changed since Mr. Abe took office. i.e. no one is yet taking his claims very seriously.

Japan 7 year breakeven

(Source of charts: Bloomberg)

But the tide has started to turn. Tokyo’s new forecast will be used to produce a fresh budget with Abe’s cabinet set to endorse a Y92.6 trillion in spending on Tuesday, Japanese media reported.

The JPY’s rapid decline has left it exposed to a mean reversion in the short term and may well reach the low 80′s in the weeks ahead (at current implied volatiltiy on the USD/JPY short term Yen calls could provide attractive asymmetry should a wider market sell-off take hold). But longer term the Yen will continue to fall substantially and Mr. Abe will succeed in raising the economy – initially – before inflation finally gets out of control, bringin Japan’s endgame ever closer.

The Fed pushes, the economy pulls. Who wins?

27 Mar

It depends who is asking.

The under-employment rate remains above 14%, the employment ratio is the lowest in decades (today’s younger generation will probably be the first to be poorer than their parents), GDP growth has stalled and income inequality is rising. 

The economy is under serious threat.

The Fed’s solution is clear: do whatever is necessary to cheapen the cost of capital enough to encourage savers to invest and cheapen the cost of loans for highly indebted borrowers.

The effects have been striking. Bond yields and mortgage rates have plummeted to historic lows. It has never been so cheap to borrow and never has cash earned to little (cash in facts yields a negative return if adjusted for inflation). So why is the economy struggling to recover?

The way that the Fed has achieved its goal has been through printing enormous quantities of money and then distributing it to holders of Governments bonds, mostly banks. 

So rates have successfully fallen but what has happened to all that cash? Most banks have parked it back with the Fed resulting in little net increase in the supply of money flowing through most people’s hands. Inflation on the whole has therefore, so far, been contained.

But the little capital that has seeped into the real economy has, in fact, caused considerable inflationary effects on some asset prices.

Equity prices have more than doubled, commodity prices have risen substantially as has the general price of food.

So who has won so far? The rich, mostly at the cost of the poor and those retired.

Those closest to the Fed’s printing press are clearly the first to benefit. Banks have been able to unwind a great deal of their highly toxic and irresponsible balance sheets enriching bankers and their clients in the process. But lower income families, those furthest from the printing press, are the worst hit. Not only does the freshly printed money never reach their pockets, but it’s effect on the price of oil and food causes a meaningful reduction on their disposable income.

For as long as current monetary policy is maintained we are likely to see this disparity worsening as income inequality continues to rise. Such direction is not only unsustainable but very dangerous to society as a whole.

The rich might become wealthier in the short term but unfortunately, in the long run, there are no winners.

Once the backbone of society breaks we are very much all losers.

Central Banks are seeking to devalue currencies. Will it ultimately destroy trust?

22 Mar

Fiat money is worth nothing without trust. History has shown that the general populace has great distrust of paper money, hence the need for its backing with some form of physical currency such as gold, silver or copper. Yet here we are, with no such backing (the gold standard was abandoned some 40 years ago), and Central Banks appear to be acting with very little regard to the value of trust.

The new Bank of England Governor, Mark Carney wants to adopt more unconventional monetary policies, Ben Bernanke has indicated that the Fed will continue to print and the Bank of Japan’s new governor has set his sights on aggressively tackling deflation through monetary easing. When everyone is so focused on one thing, it is easy to lose sight of what is really going on.

Inflationary expectations have risen consistently over the past three years. Equity markets have more than doubled from the market lows. The top 1% of US earners now account for over 21% of US total income. Inequality, not surprisingly, has risen substantially – see chart below.


(Source: Gini Co-efficient, Bloomberg)

The Gini coefficient is a measure of equality, where 0 corresponds with perfect equality and 1 corresponds with perfect inequality. US inequality has consistently been rising since the 1970′s along with the percentage of top earners that account for a greater portion of total income:

Top earners

(Source: Dylan Grice, The Edelweiss Journal)

Every crisis has a breaking point. That day may still be a long way away, but there is no doubt that we will face greater headwinds down the line.

Dylan Grice, the former global strategist at Société Générale, has recently joined Edelweiss Holdings Limited where he published last week an very interesting report on the value of trust.

The report is very much worth a read and while there is little one can do to prevent the ensuing crisis, there is no harm in being aware of what can happen when trust disappears within a society.

How will we ever get out of this mess?

11 Mar

Developed nations are heavily indebted (governments, business and individuals), unemployment is high, prices are on the rise and income inequality is only getting worse. Is it even possible to get out of this mess?

According to Richard Duncan, author of the brilliant yet very gloomily named book ‘The New Depression“, the answer is very much a yes.

It is time for another ‘Space Age’. As Kennedy announced in 1961 that the US would put a man on the moon, today’s governments should also announce an equally ambitious space project. But instead of sending a man into space, this time our attention should be focused on harnessing the energy that’s out there in space, coming straight from the sun.

Setting a target to get the entire economy fuelled solely by solar power within a specified period could leverage the economy in many ways; such a statement of intent should cause oil prices to fall rapidly resulting in an immediate boost to consumer’s disposable income and reducing the government’s trade deficit. Military spending on energy security in volatile regions would fall, further improving the budget deficit.

Mr. Duncan estimates that a $1 to $1.5 trillion investment over 10-15 years by government (potentially in association with the private sector) would boost jobs in manufacturing, R&D and lead to considerable overseas investment into the economy.

When governments can borrow at 2% for 10 years (and having very willing domestic and overseas central bank buyers of those bonds) it is difficult to argue that such investment would not yield vastly superior returns to the government, the economy and for future generations.

If only politics didn’t have to get in the way…


What is inflation?

4 Mar

For those of you wanting a fantastic overview on inflation and what effects it can have on society, you must read Culture and Inflation in Weimar Germany.

Here is a short summary what inflation means:

In economic terms, inflation is a measure of the change of prices for goods and services over a period of time.

Different measures of inflation track different goods and services to give consumers and producers an idea of how the overall price of goods and services they use changes over time.

The three most frequently used measures of inflation are:

  1. The Consumer Prices Index (CPI)
  2. The Retail Prices Index (RPI)
  3. Producer Price Index (PPI)

The objective of all these measures is similar but each will vary slightly and, in different countries, their calculation might also vary a little.

CPI, for example, typically takes into account cheaper alternatives if a specific product get too expensive whereas the RPI does not, hence why CPI is usually lower. In the US CPI includes certain housing costs such as rent whereas in the UK, while RPI takes into account mortgage interest payments and council tax, CPI does not.

In the UK the measures of inflation are calculated by the Office for National Statistics and in the US by the Bureau of Labor Statistics.

Is inflation bad?

It depends who is asking.

Simply put, inflation will erode the purchasing power of your money over time. For example in 1970 $10 would have bought you over 16 Big Macs whereas today it barely buys you 2.

In more general terms, $100 in 1970 had the same buying power as almost $600 today. The Bureau of Labor statistics has an entertaining CPI Calculator to measure how much purchasing power the dollar has lost over time.

So is inflation bad?

As a saver, unless you are able to achieve a level of return equal to the level of inflation, your purchasing power will be eroded over time. Typically, interest rates will be higher than inflation meaning that investors are able to achieve a real return on their cash – i.e. a return, net of inflation, that is positive.

However, in today’s zero interest rate environment, with inflation running at approximately 2%, cash savers will get a negative real return of 2% – i.e. their purchasing power will decrease by 2% a year.

Savers are therefore forced into seeking real returns into real assets that entail risks (such as equities, property etc.) if they are to stand any chance of achieving a positive real return. Not great. But this is exactly what the Federal Reserve is trying to get people to do. By keep real interest rates negative, they force savers into investments that, they hope, will kickstart the economy once again. A risky strategy, but more on that later.

Is inflation good?

As a borrower inflation can have its advantages so long as it does not impact your ability to repay your loan.

For example, let’s assume you get a 30-year $100,000 mortgage to buy a house today. For every year that inflation erodes the value of the dollar, the size of your debt – in real terms – falls. Just like the example above, we can assume that if the next 30 years experience similar levels of inflation to the past 30, the real value of your debt will have fallen by approximately 60%.

Mortgages are usually structured to be paid monthly rather than at the end of the term, so the average fall would be closer to 30%, but the example illustrates very clearly that inflation can aid those who borrow in nominal terms.

I wonder why the Fed would want to spur inflation at this moment in time..? I’m sure it’s got nothing to do with the $16.5 trillion in nominal debt owed by the US government…


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