Does the debt/GDP ratio drive the gold price?

September 29, 2014

The article linked HERE answers yes to the above question. The correct answer is no.

The above-linked article presents the following graph as evidence that the debt/GDP ratio (US federal government debt divided by US GDP, in this case) does, indeed, drive the US$ gold price. However, this is a classic example of cherry-picking the timescale of the data to demonstrate a relationship that isn’t apparent over other timescales. It is also a classic example of confusing correlation with causation. Many things went up in price during the 2002-2014 period covered by this graph. Should we assume that all of these price rises were caused by the increase in the US government-debt/GDP ratio?

By the way, graphs like this were far more visually appealing — although no more valid — three years ago, because the positive correlation ended in 2011. Since 2011, the debt/GDP ratio has continued its relentless advance while the gold price has trended downward. A similar graph that was popular for a while showed a strong positive correlation between the gold price and the US monetary base from the early-2000s through to 2011-2012, which created the impression that the gold price would continue to rise as long as the US monetary base continued to do the same. Again, though, this impression was the result of confusing correlation and causation.

Here’s a chart showing the relationship between the gold price and the US debt/GDP ratio over a much longer period. This chart’s message is that there is no consistent relationship between these two quantities. For example, the huge gold bull market of the 1970s occurred while the debt/GDP ratio was low with a slight downward bias and actually ended at around the time that the debt/GDP ratio embarked on a major upward trend. In fact, from the early-1970s through to the mid-1990s there appeared to be an INVERSE relationship between the gold price and the debt/GDP ratio, but this is just a coincidence. It doesn’t imply that gold was hurt by a rising debt/GDP ratio and helped by a falling debt/GDP ratio; it implies that the debt/GDP ratio isn’t a primary driver of gold’s price tend. For another example, the gold price and the debt/GDP ratio rose in parallel during 2001-2006, but the rise in the debt/GDP ratio during this period was slow and was not generally considered to be a reason for concern. Therefore, it wasn’t the driver of gold’s upward trend.

The theory that the US government debt/GDP ratio is an important driver of the US$ gold price seems to be solely based on the 3-year period from late-2008 through to late-2011, when the two rocketed upward together.

The reality is that a rising US debt/GDP ratio can be a valid part of a bullish gold story, but only to the extent that it helps to bring about lower real interest rates and/or a steeper yield curve and/or a weaker US dollar and/or rising credit spreads. It isn’t directly bullish for gold, which is why a long-term comparison of the US$ gold price and the US debt/GDP ratio shows no consistent relationship. The same can be said about a rising US monetary base.

Print This Post Print This Post

Sentiment and momentum extremes

September 26, 2014

A number of markets are currently at sentiment and momentum extremes. Generally, the Dollar Index is very extended to the upside in terms of both sentiment and momentum, whereas the markets that benefit from a weaker US$ are very extended to the downside in terms of both sentiment and momentum. With regard to the markets that are stretched to the downside, here are some of the most extreme cases based on Market Vane bullish percentages and daily RSIs (Relative Strength Indexes) over the first four days of this week. Note that a market is considered to be ‘oversold’ when its daily RSI(14) drops to 30, while a daily RSI reading of 20 or lower is a rarely-reached extreme.

1) The following extreme daily RSI(14) readings were recorded during the past four days:

– 19.2 for the Continuous Commodity Index (CCI)

– 14.3 for the TSXV Venture Exchange Composite Index (CDNX), a proxy for junior Canadian resource stocks

– 14.5 for platinum

– 15.4 for silver

– 16.4 for the silver/gold ratio

– 16.2 for the Yen (note: the daily RSIs for the euro and the Pound went below 20 earlier this month, but are now a little higher)

2) The following extremely low Market Vane bullish percentages were recorded over the past four days:

– 22% for silver (the lowest level in more than 10 years and possibly a multi-decade low)

– 20% for corn

– 14% for wheat (one of lowest levels ever, in any market)

Negative sentiment and momentum extremes do not necessarily mean that a price low is imminent. The meaning is that there will be a lot of potential energy to drive a rally after the price trend reverses.

Print This Post Print This Post

The coming US monetary tightening

September 23, 2014

Over the past 12 months I’ve written extensively at TSI about the myths surrounding US bank reserves and the relationship between bank lending and bank reserves. For example, I’ve explained that bank reserves cannot be loaned into the economy and that in the real world — as opposed to the world described in economics textbooks — banks do NOT expand credit by ‘piggybacking’ on their reserves. As part of these bank-reserve writings I addressed the reasoning behind the Fed’s decision to start paying interest on reserves, reaching the conclusion that the decision had been taken to enable the Fed Funds Rate (FFR) to be hiked in the future without contracting the supplies of reserves and money. Last week there was confirmation from the horse’s mouth that my conclusion was correct, as well as some other interesting information on how an eventual tightening of US monetary policy will proceed.

As implied above, the Fed confirmed last week that when it finally gets around to moving the FFR upward, it will do so primarily by adjusting the interest rate it pays on excess reserve balances. If not for the existence of this relatively new policy tool, the only way that the FFR could be hiked would be via the traditional method involving reductions in the supplies of reserves and money. Moreover, considering the immense quantity of excess reserves now in the banking system, there would need to be a large reduction in the supply of reserves just to achieve a 0.25% increase in the FFR. Trying to shift the FFR upward via the traditional method would therefore quickly ignite a financial crisis.

The other interesting information conveyed by the Fed last week is that the size of its balance sheet will be reduced by ceasing to reinvest repayments of principal on the securities it holds. For example, if the Fed currently owns a bond with 3 years remaining duration, then — assuming that it has embarked on a policy normalisation route — it will not reinvest the proceeds when the bond’s principal is repaid in three years’ time. Instead, the principal repayment will bring about a reduction in the Fed’s balance sheet and a reduction in the money supply.

This means that the Fed plans to reduce the size of its balance sheet — and tighten monetary policy — at a snail’s pace.

Print This Post Print This Post

Lower US living standards are an INTENDED consequence of Fed policy

September 21, 2014

The following chart is very interesting. I found it in John Mauldin’s latest “Thoughts from the Frontline” letter, although it was created by the Boston Consulting Group. It compares the cost of manufacturing in the top 25 exporting countries.


According to this chart, Australia is now the most expensive country to manufacture stuff. Manufacturing costs in Australia are now 30% higher than in the US, almost 20% higher than in Japan, almost 10% higher than in Germany, and about 5% higher than in Switzerland. The cost of manufacturing in the US is now slightly below the average — at around the same level as South Korea, Russia, Taiwan and Poland. This means that the Fed is almost half way to its goal of reducing US living standards to the point where the average factory worker in the US can compete on a cost basis with the average factory worker in Indonesia.

The above comment is only partly tongue-in-cheek. Many pro-free-market commentators discuss the decline in US living standards as if it were an unintended consequence of the Fed’s policies, but there is nothing unintended about it. It is a deliberate objective. The Fed will never come out and say “we are doing what we can to reduce living standards”, but a policy that is designed to boost asset prices, support capital-consuming businesses and promote investments that would never see the light of day in the absence of artificially low interest rates, all while minimising “wage inflation”, is also designed to reduce real wages and, therefore, to reduce living standards. The Fed surely doesn’t want to reduce US living standards to Indonesian levels, but that’s the direction in which its efforts are deliberately pointed.

I’ve explained in TSI commentaries that the root of the problem is unswerving commitment to bad economic theory. Under the Keynesian theories that all central bankers religiously follow, wealth is something that just exists. There is no careful and deep consideration given to how the wealth came to be and why some countries managed to accumulate a lot of wealth while other countries remained poor. According to these theories, people spend more during some periods due to a vague notion called rising “animal spirits”. This causes the amount of wealth to grow. Then, after a while, the mysterious “animal spirits” begin to subside, causing people to start spending less. This leads to a reduction in the amount of wealth. Under this perception of the world, one of the central bank’s primary tasks is to combat the unfathomable and destabilising natural force that drives the shifts in spending. This is done by indirectly manipulating prices throughout the economy, including the real price of labour.

The so-called counter-cyclical policies are destined to backfire, but the nature of the eventual backfiring is often difficult to predict. In broad terms, there are two possibilities: There could be a surge in inflation fear followed by a collapse in asset prices, a recession and a moonshot in deflation fear, or the collapse in asset prices and its knock-on effects could happen without a preceding surge in inflation fear. In both cases, the asset-price collapse and recession would likely usher-in a new round of ‘stimulative’ policy, because the devotion to bad theory prevents the right lessons from being learned.

Print This Post Print This Post