Gold sell-off: There is only one question that matters

goldLast Friday I participated in a (very short) debate on BBC Radio Four’s Today Programme on the future direction of gold. Tom Kendall, global head of precious metals research at Credit Suisse argued that gold was in trouble, I argued that it wasn’t. So yours truly is on record on national radio on the morning of gold’s two worst trading days in 30 years arguing that it was still a good investment.

Is it?

I still think that what I said on radio is correct and even after two days of brutal bloodletting in the gold market and two days of soul-searching for the explanations, I believe that this is the only question that ultimately matters for the direction of gold:

“Has the direction of global monetary policy changed fundamentally, or is it about to change fundamentally? Is the period of ‘quantitative easing’ and super-low interest rates about to come to an end?”

If the answer to these questions is ‘yes’ than gold will continue to be in trouble. If the answer is ‘no’, then it will come back.

Reasons to own gold

The reason for why I own gold and why I recommended it as an essential self-defense asset is not the chart pattern of the gold price, the opinion of Goldman Sachs, or the Indian wedding season but the diagnosis that the global fiat money economy has check-mated itself. After 40-years of relentless paper money expansion and in particular after 25 years of Fed-led global bubble finance, the dislocations in the global financial system are so massive that nobody in power dares to turn off the monetary spigot and allow market forces to do their work, that is to price credit and to price risk according to the available pool of real savings and the potential for real income generation rather than according to the wishes of our master monetary central planners.

The reason why for almost half a decade now all the major central banks around the world keep rates at zero and print vast amounts of bank reserves is that the system is massively dislocated and nobody wants the market to have a go at correcting this.

There are two potential outcomes (as I explain in my book): 1) This policy is maintained and even intensified, which will ultimately lead to higher inflation and paper money collapse. 2) This policy is abandoned and the liquidation of imbalances through market forces is allowed to unfold.

Gold is mainly a hedge against scenario 1) but it won’t go to zero in scenario 2) either. So far, I see little indication that central bankers are about to switch from 1) to 2) but we always have to consider the fact that the market is smarter than us and has its ears closer to the ground. What is the evidence?

Cyprus and EMU

Taken on their own, events in Cyprus were not supportive of gold, not because the island nation could potentially sell a smidgeon of gold into the market but because the EU masters decided to go for liquidation and deflation rather than full-scale bailout and reflation. Cyprus’ major bank is being liquidated not rescued and ‘recapitalized’ as in the bad examples of RBS, Northern Rock, Commerzbank, or more indirectly – via shameless re-liquification – in the case of Goldman, Morgan Stanley, Citibank and numerous others. The ECB’s balance sheet has been shrinking over the past 3 months, not expanding. Depositors in EMU (and even EU-) banks are being told that in future they shouldn’t rely on unlimited money-printing or on unlimited transfers from taxpayers in other countries to see the nominal value of their deposits protected. This is a strike for monetary sanity and a negative for gold. It should reduce the risk premium on paper money on the margin.

If this sets an example of where the global monetary bureaucracy is moving than gold is indeed in trouble. However, I don’t see it. As I argued before, it seems more likely to me that Japan is the role model for where other central banks will be heading: aggressive fiat money debasement, a last gasp attempt at throwing the monetary kitchen sink at the economy. Additionally, the EU bureaucracy may not be as principled on the question of hard or soft money when the patient brought in on a stretcher is not a European midget like Cyprus or even Greece but one of the big boys, i.e. Spain, Italy or France, the latter having been the EMU’s big accident waiting to happen for some time. Mr Draghi’s phone will immediately ring off the hook. My sense is that even in Europe the days of ‘quantitative easing’ are not numbered by any stretch of the imagination.

Bernanke, the anti-Volcker

But the central bank that really matters is the Fed. Will we one day look back on the days of April 2013 as the moment an incredibly prescient gold market told us that Bernanke was getting isolated at the Fed, that people had begun to seriously tire of his academic stubbornness about the U.S government having a technology, a printing press, that allows it to print as many dollars as it wishes….blah, blah, blah…., and finally got the knives out and finished this undignifying spectacle of madcap dollar debasement? – Of course, I don’t know but I somehow doubt it.

Yesterday was the worst day in the gold market since February 1983. Back then gold was in a gigantic bear market, not because of what Goldman thought or said, but because Paul Volcker was Fed chairman and had just applied monetary root canal treatment to the US economy simply by stopping the printing presses, allowing short rates to go up and restoring faith in the paper dollar. Hey, 20 percent on T-bills, how is that for a signal that paper money won’t be printed into oblivion! The important thing was that Volcker (and some of his political masters) had the backbone to inflict this near-term pain to achieve longer-term (although, sadly, not lasting) stability and to live with the consequences of the tightening. Today, the consequences would be much more severe, and there is also much less central banker backbone on display. Over the past two decades, the central banker has instead become the leveraged trader’s best friend. Volcker was made of sterner stuff.

If the gold market knows that easy money is about to end, how come the other markets haven’t got the news yet? Do we really believe that stocks would be trading at or near all-time highs, the bonds of fiscally challenged nations and of small-fry corporations would be trading at record low yields, if the end of easy money was around the corner?

To justified the lofty valuations of these markets on fundamentals, one would have to assume that they no longer benefit from cheap money but instead have again become the efficient-market-hypothesis’ disinterested, objective, reliable, and forward-looking barometers of our economic future, and of a bright future indeed, in which apparently all our problems – cyclical, structural, fiscal, demographic- have now been solved, so that the central bankers can pack up the emergency tool kit and gold can be sent to the museum. – Well, good luck with that.

The sucker trade

In the debate last Friday, my ‘opponent’, Tom Kendall, made a very good point. Tom said that what causes problems for gold was the ‘direction of travel’ of the economy and other asset markets. It is maybe a bit of a strange phrase but the way I understood it it is quite fitting: Equities are trading higher (in my view, mainly because of easy money and the correct expectation that easy money will stay with us) while bonds are stable and inflation (so far) is not a problem. In this environment, the gold allocation in a portfolio feels like a dead weight. For most investors it is difficult to stand on the sidelines of a rallying equity market. They need to be part of it.

I think that what is happening here is that Bernanke & Co, are enjoying, for the moment, a monetary policy sweet spot at which their monetary machinations boost equities sufficiently to suck in more and more players from the sidelines but do not yet affect the major inflation readings and do not upset the bond market. This policy is not bringing the financial system back into balance. It does not reduce imbalances or dissolve economic dislocations. To the contrary, this policy is marginally adding to long-term problems. But it feels good for now.

Bernanke is blowing new bubbles, and as we have seen in the past, it is in the early inflation phases of new bubbles that gold struggles. Equity investors are getting sucked in again, and the gold bugs may have to wait until they get spat out again and the Fed’s cavalry again rides to their rescue, that gold comes back.

In any case I remain certain of one thing:

This will end badly.

 

 

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Comments

  1. danilouxlib says

    What i really don’t understand is why the downward direction of the price of gold is the same in every currency. Following your view,that is my view, we would have different prices variations for gold: upward in us dollars, downward in euros. And in my opinion even with the same currency we should have a “german” euro price and a different “italian” euro price because real interest rates and money supply are enourmously different in those countries. What does this incoherence reflect? Just speculative mistakes in this crony market or something else we are not considering properly?

  2. says

    One other thing that has struck me about the last few days, as an aside, is the reaction of many mainstream commentators, Krugman, Ritholz and many others, who seem to be beside themselves with glee over golds fall. They have spent the last few years telling us how utterly irrelevent gold is. If this is so, why the reaction? Does Paul Krugman do cartwheels when wholesale rubber prices fall? If no one cares about the gold price, if it really has no relevence whatsoever with regard to the status of the economy then one wonders why they feel so happy when it falls. I think they protest too much.

  3. Timo says

    Detlev,

    Always a pleasure to read your insights.

    It is obvious that central banks will continue their current policies and there is no “exit strategy”. However, it is also true that vast amounts of money are created in fractional reserve banks. I have understood that due to e.g. Basel III-requirements and less risk appetite, commercial banks are lending more conservatively and money multiplier should decrease to some extent. I work in a large European commercial bank and I have noticed that lending to private sector is not wild as it was some years ago.

    In your opinion, could the risk of monetary meltdown be avoided if commercial banks simply refuse to lend more?

    • says

      I don’t think so. It may slow down the process but not change the endgame. The monetary central planners have already changed, or are in the process of changing, the monetary transmission mechanisms. Many central banks de facto fund state expenditure directly via the monetization of government debt. What the state then spends is newly created money. In Japan you see what happens when the authorities lose patience with the reflation-via-private-banks model completely: they buy equity and real estate loans directly, thus circumnavigating private banks. Additionally, in the US, I expect the Fed at some stage to stop paying interest on reserve money. This will get banks lending more aggressively again. – I don’t buy the argument that the central banks cannot – under any circumstances – debase their fiat money anymore because ‘conservative’ banks and (admittedly sizable) deflationary forces (excess capacity, overstretched balance sheets) will contain inflation forever. This does not make sense to me.

  4. Wolfie says

    What did mining shares do? If they didn’t move in unison then this was market manipulation.

    What actually has been exchanged? So what actually crashed?

    There are two ways to save a sinking ship. Either plug the hole or drain the ocean.

  5. AF says

    The fact that some are so happy about the sell-off and others may need to buy large quantities of gold to replace (for example The German gold that needs to be sent home) … could this be large scale manipulation of the price? …to enable some big players to buy at beneficial prices? ….if this is so then I guess the time to buy is now?…since I agree the fundamentals have not changed, and I can’t see all the Indians and Chinese suddenly deciding that gold is an old relic…

  6. Myno says

    I remain thankful that you are here providing sanity in the midst of turmoil. Your ability to explain complex issues clearly is a resource we dearly require in these troubled times. Keep up the good work.

  7. says

    Aloha! I continually hear this argument that gold is done when QE is done. Yet prior to QE1 the gold price was rising consistently for many years. In 2000 the POG low was $264USD and in 2009 the POG high was $1225. That was pre-QE and the POG increased over $950 or 460% gain.

    Also consider the argument about how the US economic recovery will kill off the gold rally. Is it true that the US Congress and the US FED rely on the extremely short memory of the masses to retain their power? That sort of argument about the economy is nonsense. Take the year 2006 for instance. On Jan 2006 the POG was at $530USD on Dec 28 the POG closed at $632. The POG high for 2006 was $725 in May. During 2006 the Fed Funds Rate(FFR) was above 5% and nobody could argue that the economy was NOT booming! In fact the economy was in hyper drive thanks to the real estate boom cycle. The official US FED inflation rate was still under 3% and the unemployment rate was as low as 4.4%. Contrast all that economic data to the economy we have now. What is the FFR now? Unemployment? Heck, in 2006 there was no TARP and the US credit rating was AAA even! If anyone bothers to check the US Treasury Statement you would find that banks are still borrowing from TARP in 2013.

    Somebody here, including the author should explain how the POG can rise in 2006 with a booming economy and high FFR rates yet the POG will tank in 2013 in the FFR goes to 0.50% and unemployment is double 2006?

    Let me add that on April 15, 2006(FY2006) the US Debt was at $8.3TRIL USD. On April 15, 2013(FY2013) the US Debt is at $16.7TRIL … DOUBLED in only seven years. Now imagine what the debt service on $16.7TRIL would look like if the FFR went to 5.45% the high for 2006!! Could the US economy return to the robust aggregates of 2006 with the huge debt service burden on government spending? Extremely doubtful! There is no way the US government could possibly maintain the current levels of spending if it were facing 5.45% debt service. As it is now net tax revenues cannot keep up with spending, which is why debt must be used to fill the revenue gap. If you think Ben Bernanke does not understand the consequences of rising interest rates then forfeit your PhD! Any severe cuts in US government spending would unseat the two party political monopoly now in power. What Congressman or sitting US President would want that?

  8. says

    Been looking at some charts today and it has to be said the sellof in gold and silver is part of a general drop in commodities. Copper, oil, aluminium etc etc have all been selling off. Is this advance warning of the economy rolling over and not delivering the QE fuelled recovery promised? If the Central Banks smell deflation again, surely this will ignite further intervention.

  9. Carax says

    I live in Europe, which as far as I’m concerned is in deep trouble, and for me the choice is simple. Buy gold now while there’s still a fire sale. Why? Because the alternatives are worse. The alternatives being worthless paper. How far can one trust the Euro and US Dollar? These are risky assets as far as I’m concerned, The entire global pyramid funny money Ponzi scheme seems wobbly and fragile and a black swan event could make it come crashing down.

    On another note, let’s say with 90 percent of my assets in gold and silver coin, had I been a resident of Cyprus the bank heist would merely have been an event to watch with casual interest.

    • says

      ALOHA!!

      In 2008 the media hyped the fact that when the TARP disaster hit the safe havens were US Treasuries and the USD. The downward spiral on the POG last week and continuing this week shows that the 2008 link between the POG and the USD was broken. The USD did not fulfill its past role as safe haven and in fact flatlined. The currency winner last week when the POG was routed 20% was the Yen. Right now as I type the POG is down $15 to 1362 and the USD is down .06 to 82.58. A $338 drop in the POG since Jan 1 and the USD flatlines with an “82″ handle! What happened?

      One clue is listed directly on the US Treasury Statement. It says that the Debt Ceiling will have to be raised by Congress on May 18th; a month from now. On Feb 4th Congress temporarily delayed the Debt Ceiling. Back then Obama was asking that the Debt Ceiling be eliminated. I have to agree since it is embarrassing to constantly watch the Debt Ceiling raised $1 – $1.5TRIL every year. What sort of “ceiling” is that? Its not working! Anyone see any news on CNBC about that? Did any of the multitude of market analysts on TV and the internet even mention the flatlined dollar during all this G HYPE? Literally Europe is collapsing before our eyes and gold has a huge spiral down and the USD sinks.

  10. Peter says

    Guys, do you know ‘The Chase of the Golden Meteor’ by Julius Verne? I read it ~20 years ago. Here is short description from Amazon:

    ‘The discovery of a falling golden meteor and the race to find it form the core of this exciting tale from the master of science fiction, Jules Verne. An asteroid wanders into the earth’s gravitational field and is spotted by two rival Virginia astronomers. The discovery becomes a worldwide sensation when it is announced that the asteroid is solid gold and is plummeting toward earth.’

    I remembered it when I saw recent news about NASA plans to catch an asteroid and place it in the orbit around the moon. The question is: are there any meteors nearby made of gold? How many? Could NASA haul one here? :] Think about implications…

  11. Theloh Slobus says

    Detlev may well be right that it will end badly, but there’s no reason to think that ‘badly’ means hyperinflation rather than deflation, and I suggest the evidence suggests it is far more likely to end in deflation (we’ve already binged on our inflationary bubbles, and deflation is the hangover that naturally follows). Central banks can try to delay it, but it seems no more likely that they can in practice stave it off forever than that they could keep their bubbles inflating forever. And if that’s the case then the merkets seem right to be marking down gold.

  12. Theloh Slobus says

    Oops, on re-reading my above comment I feel I should have put more emphasis on words like ‘may’ and ‘if’. After Black Thursday 1987, Ronald Reagan joked that the stock market had predicted 9 of the last 5 recessions, so I should perhaps mention that I’m a guy who has predicted two of the last zero depressions, so with any kind of decent luck I’ve hopefully now made it three of the last zero :)

  13. Laird says

    Theloh, I agree with you that deflation is the natural end of an inflationary bubble, but do you really think the bankers (especially) the politicians will permit deflation to occur as long as they can do anything to prevent it? To me, it seems more likely that we will suffer a bout of hyperinflation followed by deflation. Two for the price on one.

    • David Goldstone says

      If we do see hyperinflation, then two further possiblities follow. One is deflation, but the other is collapse of the currency and its replacement by something else. Historically the latter has tended to be the rule after hyperinflation, though the former has been the rule with (mere) high inflation.

  14. Barry Sheridan says

    Detlev, Like most ordinary folk I find it a struggle to get some sort of real perspective on how to get sound money. Your book helps, but then you come across films like this http://www.youtube.com/watch?v=U71-KsDArFM which casts a different light on the role of gold. If you get the time to watch this film entitled, The Secret of Oz, could you perhaps comment.

    • says

      It is simple. Everyone should be free to choose as money whatever they want. No law should dictate what must be accepted as payment for debt, unit of account or in taxes. Whether it will be gold is up to the market. Bill Still is a greenbacker who wishes to finance government through inflation by creating non-debt based currency units while forcing citizens to accept that money at gun point. See Gary North on this http://www.garynorth.com/public/8574.cfm

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