[This blog post is an excerpt from a recent TSI commentary]

Keynesian economic theory is useless if the aim is to understand how the world of human production and consumption works, but it is useful when attempting to figure out the policies that will be implemented in the future. The reason is that government and central bank policy-making is dominated by Keynesian ideas.

One of the most prominent Keynesian ideas is that changes in aggregate demand drive the economy. This leads to the belief that the government can keep the economy on a steady growth path by boosting its deficit-spending (thus adding to aggregate demand) during periods when economic activity is too slow and running surpluses (thus subtracting from aggregate demand) during periods when economic activity is too fast.

To further explain using an analogy, in the Keynesian world the economy is akin to a bathtub filled with an amorphous liquid called “aggregate demand”. When the liquid level gets too low it’s the job of the government and the central bank to top it up, and when the liquid level gets too high it’s the job of the government and the central bank to drain it off. Keynesian economics therefore has been called “bathtub economics”. The real-world economy is nothing like a bathtub, but that doesn’t seem to matter.

In any case, the point we now want to make is that in the US the traditional Keynesian guidelines are no longer being followed. Gone are the days of ramping-up government deficit-spending in response to economic weakness and running surpluses or at least reducing deficits when the economy is strong. These days the US federal government applies non-stop Keynesian-style stimulus and regularly exhorts the central bank to do the same. So, debt-financed tax cuts were implemented in 2017 when the economy seemed to be performing well, and now, with the unemployment rate at a generational low, the stock market near an all-time high and GDP growth chugging along at around 3%/year, the US government is planning a US$2 trillion infrastructure spending spree and the executive branch of the government is demanding that the Fed cut interest rates from levels that are already very low by historical standards.

In other words, although the ‘Keynesian bathtub’ appears to be almost over-flowing, the US government is pushing for more demand-boosting actions. The strategy is now full-on ‘stimulus’ all the time. That’s part of why it doesn’t make sense to be anything other than long-term bullish on “inflation” and long-term bearish on Treasury bonds.

[This blog post is an excerpt from a recent TSI commentary]

Here is our monthly update on what’s happening on the monetary inflation front in a few different regions/countries.

The G2 (US plus euro-zone) monetary inflation rate dropped to a 10-year low in March-2019 and has now spent 19 months below the boom-bust threshold of 6%. Refer to the following chart for details.

The low rate of G2 monetary inflation stems from the very low rate of money-supply growth in the US. During March the year-over-year (YOY) rate of growth in euro supply was 7.6%, which although well down from a 2014 peak of 14% is still quite high. The rate of growth in US$ supply, however, was only 1.8%.

The slow (by modern standards) rate of G2 money-supply growth boosts the risk that a global recession will begin in 2019, but, as noted in the past, the monetary inflation rate is a long-term indicator that leads economic and financial-market conditions by amounts of time that can vary substantially from one cycle to the next. When attempting to predict the start time of the next recession we therefore rely on other leading indicators, three of which were discussed in last week’s Interim Update.

Australia’s monetary inflation rate has picked up a little over the past few months, but the country remains on the verge of monetary deflation.

The very slow money-supply growth has had an effect on Australia’s property market, in that over the past 12 months residential property prices have fallen by an average of 6.9% on a nationwide basis and 10.9% in Sydney (the largest and most expensive city in Australia). Refer to the article posted HERE for more detail.

Actually, the decline to near zero in Australia’s monetary inflation rate is both a cause and an effect of the slight (to date) deflation of the property investment bubble. Commercial banks have been making it more difficult for house buyers to obtain credit, leading to a pullback in prices and a slowdown in the pace at which new money is created.

In January-2019 the year-over-year (YOY) growth rate of China’s M1 money supply dropped to its lowest level since 1989. There was an insignificant up-tick in February, but the recent attempts by China’s government to promote credit expansion started to ‘bear fruit’ in March. Refer to the following chart for details.

We wonder if this is too little too late to kick-start a new surge in the demand for industrial commodities.

Hong Kong hasn’t escaped the general monetary-inflation slowdown. As illustrated below, the YOY rate of growth in HK’s M2 money supply has languished near a 10-year low in the 1%-4% range over the past several months.

Remarkably, HK’s low monetary inflation rate is yet to have a pronounced effect on the world’s most expensive real estate. Property prices dropped in HK during August-December of last year, but they rose in January and the majority view is that a rise to new highs is in store.

Due to the monetary backdrop, we think there’s a high risk of a double-digit decline in HK property prices over the next 12 months.

Almost everyone knows that the Bank of Japan (BOJ) has pumped a huge amount of money into the Japanese economy, so the lack of “price inflation” in Japan is something of a quandary. Analysts have let their imaginations run wild in an attempt to explain this strange set of circumstances, and the situation in Japan has even been cited as proof that increasing the money supply doesn’t cause prices to rise. However, anyone who didn’t blindly assume that the BOJ’s actions were leading to rapid money-supply growth and instead took the trouble to check what was actually happening to Japan’s money supply would quickly realise that explaining Japan’s lack of “price inflation” requires no stretch of the imagination. The fact is that Japan’s monetary inflation rate over the past 25 years has been consistent with an “inflation” rate of approximately zero.

The persistently low rate of monetary inflation in Japan is illustrated by the following chart. The chart shows that the YOY rate of increase in Japan’s M2 money supply averaged about 2% over the past 27 years and about 2.5% over the past 10 years. It is currently about 2.4%. Assuming productivity growth of 2%-3%, these money-supply figures are consistent with a flat general price level.

Note that QE in Japan is different from QE in the US. When the Fed implements QE it boosts the supply of bank reserves and the supply of money on a one-for-one basis (bank reserves aren’t counted in the money supply), but the BOJ’s QE adds far more to bank reserves than to the money supply. Note also that the Fed’s QE created a lot less “price inflation” than many people were expecting for the reasons outlined HERE.

The Japanese economy has benefited from the persistently slow rate of monetary inflation and the resulting stability of the currency, but at the same time it has been hurt by the massive diversion of resources to the government. The net result is an economy that isn’t exactly vibrant, but also isn’t that bad.

To summarise the above information, the pace at which new money is being created around the world remains unusually slow.

An increase in the amount of gold bullion held by GLD (the SPDR Gold Shares) and other bullion ETFs does not cause the gold price to rise. The cause-effect works the other way around and in any case the amount of gold that moves in/out of the ETFs is always trivial compared to the metal’s total trading volume. However, it is reasonable to view the change in GLD’s gold inventory as a sentiment indicator.

Ironically, an increase in the amount of physical gold held by GLD and the other gold ETFs is indicative of increasing speculative demand for “paper gold”, not physical gold. As I explained in previous blog posts (for example, HERE), physical gold only ever gets added to GLD’s inventory when the price of a GLD share (a form of “paper gold”) outperforms the price of gold bullion. It happens as a result of an arbitrage trade that has the effect of bringing GLD’s market price back into line with its net asset value (NAV). Furthermore, the greater the demand for paper claims to gold (in the form of ETF shares) relative to physical gold, the greater the quantity of physical gold that gets added to GLD’s inventory to keep the GLD price in line with its NAV.

Speculators in GLD shares and other forms of “paper gold” (most notably gold futures) tend to become increasingly optimistic as the price rises and increasingly pessimistic as the price declines. That’s the explanation for the positive correlation between the gold price and GLD’s physical gold inventory illustrated by the following chart. That’s also why intermediate-term trend reversals in the GLD gold inventory tend to follow reversals in the gold price. The thick vertical lines on the following chart mark the intermediate-term trend reversals in the US$ gold price.

Interestingly, the increase in the GLD inventory that occurred in parallel with the most recent upward trend in the gold price was relatively small. This suggests that the price rally was driven more by increasing demand for physical gold than by increasing demand for paper gold. Furthermore, the minor downward correction in the gold price since the February-2019 short-term peak has been accompanied by a disproportionately large decline in GLD’s physical inventory. In fact, at the end of last week GLD held about 30 tonnes less gold than it did when the gold price was bottoming in the $1170s last August. Again, this suggests that the gold price has been supported by demand for the physical metal.

In terms of influence on the gold price, speculative trading of gold futures is vastly more important than speculative trading of GLD shares. Therefore, assumptions about paper versus physical demand shouldn’t be based solely on the change in the GLD inventory. The situation in the gold futures market also must be taken into account.

I won’t get into the details in this post, but changes in futures-market positioning and open interest over the past few months are consistent with the idea that the demand for physical gold has been strong relative to the demand for paper gold.

The relatively strong demand for physical gold does not imply that a big gold-price rally is coming, but it does imply that the downside price risk is low.

If you look hard enough you will always be able to find reasons that the gold price is about to rocket upward, because such reasons always exist regardless of whether gold’s prospects are bullish or bearish. More generally, searching for reasons that something specific is about to happen is a bad way to speculate or invest because it will always be possible to find evidence to support any preconceived view. Rather than attempting to justify preconceived views, it is much better to approach the markets with an open mind and to base buy/sell decisions on objective indicators with good long-term track records.

One of the financial world’s most reliable indicators is the gold/commodity (g/c) ratio. The g/c ratio is more predictable than the US$ gold price, or to be more accurate the g/c ratio has a more consistent relationship with other markets than does the US$ gold price. This is possibly because removing the ever-changing dollar from the equation suppresses ‘noise’ and amplifies ‘signal’.

The following chart is an example of the g/c ratio’s consistent, and therefore predictable, relationship with another market. It shows that almost all of the time the g/c ratio (as represented by the US$ gold price divided by the GSCI Spot Commodity Index) trends in the same direction as credit spreads (represented here by the IEF/HYG ratio).

The relationship depicted below is sufficiently reliable that if you know, or at least have a good idea regarding, what will happen to credit spreads over a certain period, then you will be able to accurately forecast whether gold will strengthen or weaken relative to the average commodity over the period. By the same token, knowledge about whether gold is poised to strengthen or weaken relative to the average commodity leads to a high-probability forecast about credit spreads.

There are other inter-market relationships involving the g/c ratio that work just as well as the one mentioned above, and at the beginning of this year I used one of these to forecast that gold would be weak relative to commodities during the first half and strong relative to commodities during the second half of 2019. The first-half forecast has panned out to date. The second-half forecast still looks plausible but is subject to revision based on what happens to various indicators over the next couple of months.

Another of the financial world’s most reliable indicators is sentiment. An accurate reading of market sentiment doesn’t lead to specific conclusions about future price movements, and as discussed HERE there are pitfalls associated with using sentiment to guide buy/sell decisions. However, understanding how sentiment affects the markets can give an investor a decisive edge.

I’m not going to write about why or how sentiment can be used to good effect when attempting to time buys and sells in the financial markets. I’m also not going to mention the most useful indicators of market sentiment. The reason is that Bob Moriarty has covered this ground and more in his latest book: “Basic Investing in Resource Stocks: The Idiot’s Guide“. The Kindle version of the book is only US$6, or just a little more than the price of a large cappuccino at my local cafe.

Bob’s book is essential reading for anyone speculating in junior resource stocks, especially anyone who is inexperienced or hasn’t coped well with the huge swings in these stocks in the past.

At one point during the book I thought that Bob was making successful speculation in the stocks of small mining and oil companies seem too easy, because the hard reality is that even when you understand the most effective way to trade these stocks you still will stumble into traps from time to time. However, later in the book Bob warns the reader that large losses can happen even when all the ducks appear to be in a row. He does this by recounting some amusing stories about his own failed speculations and the management teams that helped to create these failures.

Even if you already know how to use sentiment and how to operate profitably at the speculative end of the stock market, you will get something out of the Bob Moriarty book linked above. It’s well worth the 6 bucks for the electronic version or the 12 bucks for the paper version.

A popular view is that the Fed has given up on monetary tightening and as a result the stock market should continue to trend upward over the months ahead. This view is based on flawed reasoning.

The reality is that the Fed possibly will give up on monetary tightening later this year, but currently the Fed is pulling quite firmly on the monetary reins via its on-going balance-sheet normalisation (that is, balance-sheet reduction) program. Moreover, the Fed’s on-going withdrawal of money from the economy is not being fully offset by the actions of the commercial banks, so the overall US money-supply situation is becoming increasingly restrictive. This is evidenced by the following chart of the year-over-year (YOY) change in US True Money Supply (TMS). The chart shows that in March-2019 the US monetary inflation rate made a 12-year low.

However, the unusually slow pace of US money-supply growth is not a good reason to be short-term bearish on the US stock market. This is partly because changes in the financial markets lag changes in the monetary backdrop by long and variable amounts of time. It is also because of a point that was covered in a TSI blog post about three weeks ago.

The point I’m referring to is that whether the overall monetary situation is ‘tightening’ or ‘loosening’ is not solely determined by the change in money supply. Instead, over periods of up to a few years the change in the demand for money (meaning: the change in the desire to hold/obtain cash as an asset) often will dominate the change in the supply of money.

In general terms, the change in overall liquidity is determined by the change in the supply of money relative to the change in the demand to hold cash or cash-like securities. As a consequence, it’s possible for the liquidity situation to be tight even if the monetary inflation rate is very high and/or rapidly increasing. A great example is the period from September-2008 to March-2009, when a large and fast increase in the US money supply was more than offset by a surge in the demand for money. Also, it’s possible for there to be abundant liquidity even if the monetary inflation rate is very low. A good example occurred over the past 3-4 months.

Although the supply side of the monetary equation tends to be dominated by the demand side of the equation over the short-to-intermediate-term, today’s unusually low monetary inflation rate is still significant. It means that only a small increase in the demand to hold cash could bring about another plunge in the stock market. To put it another way, due to the low monetary inflation rate the US stock market is far more vulnerable than usual to a short-term increase in risk aversion.

Taking a wider-angle view, the money-supply situation also leads to the conclusion that if a bear market did not begin last year (it most likely didn’t) then it will begin by the second half of next year at the latest. Other indicators will be required to narrow-down the timing.

[In a blog post last October I mentioned that a recent divergence between the gold/commodity ratio and the T-Bond price had bullish implications for the T-Bond. A strong rebound in the T-Bond soon got underway. Another divergence between the gold/commodity ratio and the T-Bond price has since developed, this time with bearish implications for the T-Bond. A discussion of the most recent divergence was included in a TSI commentary published on 28th March and is reprinted below.]

The gold/commodity (g/c) ratio and the T-Bond price tend to move in the same direction. As previously explained, this tendency is associated with what Keynesian economists call a paradox (“Gibson’s Paradox”) and Austrian economists call a natural and perfectly understandable consequence of the relationship between time preference and prices. The reason for revisiting the gold-bond relationship today is that a significant divergence developed over the past three months and such divergences are usually important.

The following chart illustrates our point that the gold/commodity ratio (the US$ gold price divided by the GSCI Spot Commodity Index) and the T-Bond price move in the same direction most of the time. It also shows that over the past three months the two quantities have diverged, with the g/c ratio trending downward while the T-Bond price extended its upward trend and moved to a marginal new 12-month high.

Given that the relationship between the g/c ratio and the T-Bond has a solid fundamental basis, that is, given that it’s not a case of random correlation, it should continue to apply. Therefore, we expect that the divergence will close over the months ahead — via either a rise in the g/c ratio to above its December-2018 high or a decline in the T-Bond price to well below its February-2019 low.

The divergence probably will close via a decline in the T-Bond price, because if there is a leader in this relationship it is the g/c ratio. For example, in each of the three biggest divergences of the past five years (the areas inside the blue boxes drawn on the above chart), the g/c ratio reversed course months in advance of the T-Bond. The g/c ratio also led the T-Bond by 2-3 months at the Q3-2017 top and by a couple of weeks at the Q4-2018 bottom. In other words, the recent performance of the g/c ratio is a reason to be intermediate-term bearish on the T-Bond.

One realistic possibility is that the T-Bond is now topping similarly to how it bottomed between December-2016 and March-2017. Back then, both the g/c ratio and the T-Bond turned up at around the same time (in late December of 2016), but whereas the g/c ratio trended upward throughout the first quarter of 2017 the T-Bond made a marginal new low in March before commencing an upward trend of its own. This time around the g/c ratio and the T-Bond turned down at around the same time (in late December of 2018), but whereas the g/c ratio has continued along a downward path the T-Bond has risen to a marginal new multi-month high.

[This blog post is an excerpt from a recent TSI commentary]

The Quantity Theory of Money (QTM) holds that the change in money Purchasing Power (PP) is proportional to the change in the Money Supply (MS). It’s a bad theory, because it doesn’t reflect reality.

There are three main reasons that QTM doesn’t work in the real world, the first being that money PP can’t be expressed as a single number. There is no such thing as the “general price level”. Instead, at any point in time there are millions of individual prices that cannot be averaged to arrive at something sensible. That being said, QTM wouldn’t work even if it were possible to determine the “general price level”.

The second reason that QTM doesn’t work in the real world is that new money never gets injected uniformly throughout the economy. A consequence is that different prices get affected in different ways at different times, depending on who the first receivers of the new money happen to be. For example, during normal times the commercial banks are responsible for almost all money creation, with new money entering the economy via loans to the banks’ customers, whereas during 2008-2014 most new US dollars were created by the Fed and injected into the financial markets via the purchasing of bonds.

However, even if there existed a single number that accurately represented money PP and new money was injected uniformly throughout the economy, the Quantity Theory of Money STILL wouldn’t work. The reason is that as is the case with the price of anything, the price of money is determined by supply AND demand. (As an aside, in the real world there is no such thing as money velocity.) In other words, the price (PP) of money never could be properly explained/understood by reference to only the supply of money. We’ll now expand on this point.

Over the very long term, changes in money supply dominate changes in money demand, where by money demand we mean the desire to hold cash as an asset rather than the desire to obtain money to facilitate current purchases. However, during periods of up to a few years the change in money demand often will dominate the change in money supply. A good example is September 2008 through to March 2009. During this period the Fed rapidly increased the money supply, but the Fed’s actions were overwhelmed by increasing demand for money. Furthermore, when prices suddenly started rising in March-April of 2009 it was not only because the money supply had grown, but also because the demand for money had begun to fall.

In relation to the above it’s important to understand that in addition to affecting the supply of money, the Fed and other central banks affect the demand for money. This is very relevant to the recent past. Over the past three months the Fed continued to reduce the money supply, but statements emanating from the Fed had the effect of reducing the desire to hold cash. The net effect was a general increase in ‘liquidity’ even while the Fed acted to reduce the money supply.

Unfortunately, there is no way to analyse the monetary situation that is both simple and accurate. In particular, there is no simple equation that indicates the real-world relationship between money supply and money purchasing-power.

I haven’t discussed gold’s true fundamentals* at the TSI Blog since early December of last year, at which time I concluded: “All things considered, for the first time in many months the true fundamentals appear to be slightly in gold’s favour. If the recent trend in the fundamental situation continues then we should see the gold price return to the $1300s early next year…” The “recent trend in the fundamental situation” did continue, enabling my Gold True Fundamentals Model (GTFM) to turn bullish at the beginning of this year (after spending almost all of 2018 in bearish territory) and paving the way for the US$ gold price to move up to the $1300s.

The following weekly chart shows that after moving slightly into the bullish zone (above 50) at the beginning of January, the GTFM has flat-lined (the GTFM is the blue line on the chart, the US$ gold price is the red line). Based on the current positions of the Model’s seven inputs, its next move is more likely to be further into bullish territory than a drop back into bearish territory.

As an aside, the bullish fundamental backdrop does not preclude some additional corrective activity in the near future.

The most important GTFM input that is yet to turn bullish is the yield curve, as indicated by the 10year-2year yield spread or the 10year-3month yield spread. This input shifting from bearish to bullish requires a reversal in the yield curve from flattening (long-term rates falling relative to short-term rates) to steepening (long-term rates rising relative to short-term rates). If the reversal is driven primarily by falling short-term interest rates it indicates a boom-to-bust transition, such as occurred in 2000 and 2007, whereas if the reversal is driven primarily by rising long-term interest rates it points to increasing inflation expectations.

As illustrated below, at the end of last week there was no evidence of such a trend change in the 10year-3month yield spread.

The US$ gold price could rise to the $1400s during the second quarter of this year as part of an intermediate-term rally, but to get a gold bull market there probably will have to be a sustained trend reversal in the yield curve.

*I use the term “true fundamentals” to distinguish the actual fundamental drivers of the gold price from the drivers that are regularly cited by gold-market analysts and commentators. According to many pontificators on the gold market, gold’s fundamentals include the volume of metal flowing into the inventories of gold ETFs, China’s gold imports, the volume of gold being transferred out of the Shanghai Futures Exchange inventory, the amount of “registered” gold at the COMEX, India’s monsoon and wedding seasons, jewellery demand, the amount of gold being bought/sold by various central banks, changes in mine production and scrap supply, and wild guesses regarding JP Morgan’s exposure to gold. These aren’t true fundamental price drivers. At best, they are distractions.

[This blog post is a modified excerpt from a TSI commentary published about a month ago]

Modern Monetary Theory, or MMT for short, is gaining popularity in the US. It is based on the idea that under the current monetary system the government doesn’t have to borrow. Instead, it simply can print all the money it needs to fill the gap between its spending and its income. The only limitation is “inflation”. As long as “inflation” is not a problem the government can spend — using newly-created money to finance any deficit — as much as required to ensure that almost everyone is gainfully employed and to provide all desired services and infrastructure. It sounds great! Why hasn’t anyone come up with such an effective and easy-to-implement prosperity scheme in the past?

Of course it has been tried in the past. It has been tried countless times over literally thousands of years. The fact is that there is nothing modern about Modern Monetary Theory. It is just another version of the same old attempt to get something for nothing.

Most recently, MMT was put into effect in Venezuela. For all intents and purposes, the government of Venezuela printed whatever money it needed to pay for the extensive ‘free’ social services it promised to the country’s citizens. The MMT apologists undoubtedly would argue that the money-printing experiment didn’t work in Venezuela because the government didn’t pay attention to the “inflation” rate. It kept on printing money at a rapid pace after “inflation” became a problem. Our retort would be: “Great point! Who would have thought that a government with the power to print money couldn’t be trusted to stop printing as soon as an index of prices moved above an arbitrary level.”

In essence, MMT is based on the fiction that the government can facilitate an increase in overall economic well-being by exchanging nothing (money created ‘out of thin air’) for something, or by enabling the recipients of the government’s largesse to exchange nothing for something. It is total nonsense, although there is an obvious reason that it appeals to certain politicians. Its appeal to the political class is that it superficially provides an easy answer to the question that arises when politicians promise widespread access to valuable services free of charge. The question is: “Who will pay?” According to MMT, nobody pays until/unless “inflation” gets too high.

And what happens when inflation gets too high? Well, according to MMT the government simply ramps up direct taxation to reduce the spending power of the private sector, which supposedly quells the upward pressure on prices.

Therefore, MMT can be viewed as a case of heads the government wins, tails the private sector loses. As long as “inflation” is below an arbitrary level the government can extract whatever wealth it wants from the private sector indirectly by printing money, and if “inflation” gets too high the government can extract whatever wealth it wants from the private sector via direct taxation.

The crux of the issue is that new wealth can’t be created by printing money, but existing wealth will be redistributed. It’s like when a private counterfeiter prints new money for himself. When he spends that money he diverts real wealth to himself while contributing nothing to the economy. MMT is the same principle applied on a gigantic scale.

That being said, MMT does have its good points, just not the good points that its proponents claim.

As happens when money is loaned into existence under the current system, the application of MMT will affect relative prices as well as the so-called “general price level”. The reason is that the new money won’t be injected uniformly across the economy. However, it’s likely that the price increases stemming from the monetary inflation will be more uniform and direct under MMT than under the current system. In other words, under MMT the effects of monetary inflation should be reflected much sooner and to a far greater extent in the CPI than is the case with the current system.

That the application of MMT would lead quickly to what most people think of as “inflation” is a benefit, because the link between cause (monetary inflation) and effect (rising prices) would be obvious to almost everyone. A related benefit is that MMT would short-circuit the boom-bust cycle.

Booms happen when the Fractional Reserve Banking (FRB) system (with or without a central bank) expands credit and in doing so creates the impression that the quantity of real savings is much greater than is actually so. This prompts excessive investment in long-term business ventures that would not look viable in the absence of misleading interest-rate signals.

We assume that under MMT the commercial banks still would be lending new money into existence, but the temporary downward pressure on interest rates from the surreptitious money creation of the banks would be more than offset by the upward pressure on interest rates from the blatant money-printing of the government. The boom phase therefore would be very short, perhaps even barely noticeable. In effect, MMT would bypass the boom and go straight to the bust. Again, this would be beneficial because it would expose the link between cause (the application of a crackpot monetary theory) and effect (economic hardship for most people).

MMT is such an obviously silly idea that any economist, politician, journalist or financial-market commentator who advocates it should not be taken seriously. However, that they are being taken seriously opens up the possibility that MMT will be implemented in the not-too-distant future, with the ‘benefits’ outlined above.

It’s likely that by the middle of the next decade, most new cars, trucks and buses will be Electric Vehicles (EVs). As a consequence, it’s a good bet that over the next several years the demand for both gasoline and diesel will shrink dramatically while the demand for electricity (to recharge EV batteries) experiences huge growth. Part of this demand growth will be satisfied by nuclear power, which is why uranium is an indirect play on the EV trend.

The uranium price might have begun to discount the aforementioned shift in demand in that it has been quietly trending upward since around April of last year (a weekly chart is displayed below). I say “quietly” because the rally has been accompanied by very little in the way of speculative enthusiasm. On the contrary, the rally that began last April has been accompanied by widespread scepticism.

This is an important sentiment change. Whereas every multi-month up-move in the uranium price prior to last year was greeted as if it heralded the beginning of a bull market, almost everyone has dismissed the most recent rally as just another counter-trend bounce. Being bearish on uranium has become easy, but bull markets begin when it’s easy to be bearish.

I’m not convinced that a uranium bull market is underway, but I do think that for the uranium-mining sector the intermediate-term risk/reward is skewed decisively towards reward. The reason is that the mining stocks could achieve large price gains with or without a genuine bull market in the underlying commodity. All it would take, I think, is a move by the uranium price into the $30s to convince many speculators that a major trend reversal had occurred and prompt aggressive buying of uranium-mining equities.

It used to be that owning shares of the Global X Uranium Fund (URA) was the simplest and surest way of participating in a uranium-mining rally, but that is no longer the case due to the changes that were made to this fund last year. As outlined HERE, during the second quarter of last year the index that URA tracks was changed from the Solactive Global Uranium Total Return Index to the Solactive Global Uranium & Nuclear Components Total Return Index. Thanks to this change, seven of URA’s current top ten holdings have no correlation with the uranium price.

Nowadays, owning the shares of Cameco (CCJ) is the surest way of participating in a uranium-mining rally.

It looks to me like CCJ is not far from completing a 3-year base (see chart below). I like the idea of gradually building up a position on weakness while the basing process continues.

[This blog post is an excerpt from a TSI commentary published on 24th February]

Based on the par value of maturing securities on its balance sheet there was scope for the Fed to withdraw as much as $43B from the financial markets on 15th February. A week ago we noted that this ‘liquidity drain’ had no effect on the stock market, possibly because the effect would occur on the next trading day (Tuesday 19th February) or because the Fed chose to withdraw a lot less money than it could have. Now that the Fed has issued its latest weekly balance sheet update we can see why there was no effect from this potential bout of “quantitative tightening” (QT). We can also see that the general perception of what the Fed is doing has deviated in a big way from what the Fed actually is doing.

During the 7-day period from 13th to 20th February the Fed’s securities portfolio fell by $31B. In other words, the Fed implemented $31B of a potential maximum $43B of QT. Over the same period, however, the amount of money in the US federal government’s account at the Fed fell by $44B. This means that there was a $31B withdrawal of liquidity by the Fed in parallel with a $44B injection of liquidity by the government, resulting in a net liquidity ADDITION of $13B. No wonder there wasn’t a noticeable negative effect on the stock market from the Fed’s actions.

The difference between a Fed liquidity injection and a government liquidity injection is that whereas the Fed can inject new money, the government can only recycle existing money (the government returns to the economy the money it previously removed via borrowing or taxation). Government liquidity injections therefore are not inflationary, but their short-term effects can be similar to Fed liquidity injections.

Note that at 20th February the government had about $330B in its account at the Fed. This means that the government currently has the ability to inject up to $330B into the economy, but depending on the size of its desired cash float it may or may not make additional injections in the short-term.

Also note that notwithstanding all of the ‘dovish’ talk that has emanated from the Fed over the past two months, the QT program has continued. From 2nd January to 20th February the Fed removed $63B from the economy as part of its “balance sheet normalisation”. The pace of the liquidity removal is slower than the Fed’s self-imposed $50B/month limit, but it is not correct to say — as some pundits have said — that the Fed has stopped tightening. The Fed is still pulling on the monetary reins.

That the Fed is still tightening means that there is a substantial mismatch at the moment between perception and reality. The general perception is that the Fed is now either on hold or preparing to loosen, but, as mentioned above, this most definitely is not the case. Consequently, bullish speculators in the stock, commodity and gold markets are getting ahead of themselves.

It’s possible that the Fed will end its monetary tightening within the next few months, but that’s only going to happen if there’s another pronounced shift away from risk. To put it another way, the more the markets discount an easing of monetary policy the less chance the easing will occur. In fact, if the stock market extends its upward trend into May-June then the Fed probably will resume its rate-hiking in June.

Like every other financial market in world history, the gold market is manipulated. However, anyone who believes that manipulation of the gold market is an important influence on major gold-price trends does not understand the true fundamental drivers of the gold price.

To paraphrase Jim Grant, gold’s market value is the reciprocal of confidence — in the banking system (including the central bank), the economy and the government. In other words, gold should do relatively well when confidence is on the decline and relatively poorly when confidence is on the rise.

By comparing the gold/commodity ratio with measures of monetary and/or economic confidence it can be shown that gold generally does exactly what it should do. There are periods of divergence, but these tend to be short (no more than a few months) and barely noticeable on long-term charts.

The point outlined above can be illustrated by comparing the gold/commodity (gold/GNX) ratio with the IEF/HYG ratio, which I’ve done in the following chart.

The IEF/HYG ratio is fit for our purpose because it is a measure of what’s happening to credit spreads, and because the economy-wide credit-spread trend is one of the best indicators of economic confidence. Specifically, the IEF/HYG ratio increases when credit spreads are widening (indicating declining economic confidence) and decreases when credit spreads are narrowing (indicating rising economic confidence).

Therefore, it is fair to say that the following chart compares the gold/commodity ratio with the reciprocal of confidence in the US economy.

Lo and behold, the two lines on the chart track each other quite closely.

[This blog post is an excerpt from a commentary posted at TSI about three weeks ago]

TARGET2 is the system set up in the euro-zone to clear inter-bank payments. The Bundesbank (Germany’s central bank) describes it as a payment system that enables the speedy and final settlement of national and cross-border payments. The problem is that often there is no “final settlement” under TARGET2. Instead, credits and debits can build up indefinitely.

To understand the issue it first must be understood that although the 19 countries that comprise the euro-zone use a common currency, the euro-zone isn’t really a unified monetary system. It is more like 19 separate monetary systems, each of which is overseen by a National Central Bank (NCB). These NCBs are, in turn, overseen and coordinated by the ECB. TARGET2 is the means by which money is transferred quickly and efficiently between these 19 separate monetary systems. The transfer may well be quick and efficient, but, as noted above, it often doesn’t result in final settlement.

Further explanation is provided by the Bundesbank, as follows:

“…both the Bundesbank and the Banque de France will be involved in a cross-border payment transaction made in settlement of a German export to France, for instance. That transaction begins when the French importer’s commercial bank in France debits the purchase amount from the importer’s account and submits a credit transfer in TARGET2 to the German exporter’s commercial bank in Germany. The Banque de France then debits the amount from the TARGET2 account it operates for the French commercial bank and posts a liability owed to the Bundesbank. For its part, the Bundesbank posts a claim on the Banque de France and credits the amount to the German commercial bank’s TARGET2 account. The transaction is concluded when the commercial bank credits the amount in question to the account it operates for the German exporter.

At the end of the business day, all the intraday bilateral liabilities and claims are automatically cleared as part of a multilateral netting procedure and transferred to the ECB via novation, leaving a single NCB liability to, or claim on, the ECB.

Viewed in isolation, the transaction used as an example above leaves the Banque de France with a liability to the ECB and the Bundesbank with a claim on the ECB at the end of the business day. These claims on, or liabilities to, the ECB are generally referred to as TARGET2 balances.”

The example given above by the Bundesbank refers to a German export to France, but the same process would apply when someone transfers money from a bank deposit in one EZ country to a bank deposit in another EZ country. For example, the electronic wiring of funds from a commercial bank account in Italy to a commercial bank account in Luxembourg would leave the Banca d’Italia with a liability to the ECB and the Banque Centrale du Luxembourg with a claim on the ECB.

The process described above means that there is never any net clearing of cross border payments at the NCB level. Unless the money flowing in one direction (into Country X) equals the money flowing in the opposite direction (out of Country X), credit/debit balances will build up and there is no limit to how large these balances can become.

As illustrated by the following chart from Yardeni.com, this is not just a hypothetical issue. The NCBs of some EZ countries, most notably Germany and Luxembourg, now have huge positive TARGET2 balances, and the NCBs of some other EZ countries, most notably Italy and Spain, now have huge negative TARGET2 balances.

As at October-2018, the central bank of Germany was owed 928 billion euros by the TARGET2 system, while together the central banks of Italy and Spain owed 887 billion euros to the TARGET2 system. Is this a problem?

The system is so strange that there doesn’t appear to be a clear-cut answer to the above question, at least not one that we can fathom. It could be a huge problem or it could be no problem at all.

The Bundesbank is sitting there with an asset valued at almost 1 trillion euros that will never pay any interest and cannot be collected. At first blush this appears to be a huge problem. It implies that at some point the asset will have to be written off, perhaps leading to a very expensive bailout funded by German taxpayers. But then again, due to the way the current monetary system works it may well be possible for TARGET2 balances to grow indefinitely with no adverse consequences. That’s why we haven’t devoted any commentary space to this issue in the past.

If we were forced to give an answer to the above question it would be that rising interest rates, burgeoning government debt levels and private bank failures will become system-threatening issues in the EZ long before the TARGET2 balances pose a major threat.

Bank reserves are a throwback to a time when the amount of receipts for money (gold) that could be issued by a bank was limited by the amount of money (gold) the bank held in reserve. Under the current monetary system bank reserves have no real meaning, since it isn’t possible for a dollar in a bank deposit to be genuinely backed by a dollar held somewhere else. The dollar can’t back itself! However, it is still important to understand what today’s bank reserves are/aren’t and how changes in the reserves quantity are linked to changes in the economy-wide money supply. Remarkably, these bank-reserve basics are misunderstood by almost everyone who comments on the topic.

The simplest way for me to deal with the common misunderstandings about bank reserves is in point form, so that’s how I’ll do it. Here goes:

1) Bank reserves aren’t money, that is, they are not considered to be general media of exchange and are not counted in the True Money Supply (TMS). Instead, they provide ‘backing’ for part of the money supply.

2) A corollary of the above is that banks can’t use their reserves to buy things outside the Federal Reserve system.

3) Banks can lend their reserves to other banks, but the banking industry as a whole cannot expand or shrink its reserves. In other words, the banking industry has no control over its collective reserves. The central bank has total control.

4) Bank reserves can be shifted around within accounts at the Fed, but the only way that reserves can leave the Fed and enter the economy is via the withdrawal, by the public, of physical currency from banks. For example, when $100 is withdrawn from an ATM, $100 is converted from deposit currency to physical currency. This doesn’t alter the money supply, but it causes the bank to lose a $100 liability (the bank customer’s deposit) and a $100 asset (the physical currency held in the bank’s vault). When the quantity of physical currency held in a bank’s vault gets too small, the bank will replenish its supply by withdrawing reserves from the Fed in the form of new paper dollars. Although it may appear that this imposes some sort of limit on the supply of physical dollars, the Fed stands ready, willing and able to meet any increase in demand. This is further discussed in point 5).

5) Under the current monetary system, reserves effectively are created out of nothing. To be more precise, the Fed creates reserves when it purchases bonds and other assets. Since there is no limit to the dollar value of assets that can be purchased by the Fed, the banking system will never run short of the reserves it needs to meet the public’s demand for physical currency. Also, the Fed can remove reserves whenever it wants by selling bonds and other assets.

6) Except for the siphoning of reserves in response to the public’s increasing demand for physical currency, it is accurate to say that reserves at the Fed stay at the Fed until they are removed by the Fed. A corollary — as already mentioned in point 3) — is that the commercial banking industry cannot draw-down its reserves.

7) The Fed pays interest on ALL reserves, not just so-called “excess reserves”. In any case and as outlined below, for all intents and purposes all US bank reserves, with the exception of the relatively small portion required to meet any increase in the demand for physical currency, are now excess and have been for the past few decades.

8) The way the US monetary system now works it is fair to say that all reserves are excess. The reason is that the quantity of bank reserves has no bearing on the amount by which banks expand/contract credit. In effect, the US now has a zero-reserve fractional reserve banking system. That’s why it was possible for the greatest expansion of bank credit in modern US history, which took place during 1990-2007, to happen while the commercial banking industry had almost no reserves. During this period total bank credit rose by $6 trillion, from $2.5T to $8.5T, while bank reserves at the Fed dwindled from $64B to $40B.

9) Further to point 8), bank lending doesn’t ‘piggy-back’ on bank reserves. It possibly did 40 years ago, but it hasn’t for at least the past 25 years. Hopefully, economics textbooks eventually will be updated to reflect this reality.

10) An implication of points 7) and 8) is that interest payments on reserves are neither an incentive nor a disincentive to bank lending. When a bank makes a loan to a customer it doesn’t lose any reserves and therefore continues to collect the same interest-on-reserves payment from the Fed.

11) The sole purpose of paying interest on reserves is to enable the Fed to hike the Fed Funds Rate during a period when the banks are inundated with reserves, without having to massively reduce the quantity of reserves. This was discussed in previous blog posts, for example HERE.

12) When the Fed was ‘quantitatively easing’ many pundits wrote that it was adding to bank reserves but not the money supply. This is wrong. When the Fed buys X$ of securities as part of a QE program it adds X$ to bank reserves AND it adds X$ to the economy-wide money supply. I previously described the process HERE.

13) By the same token, now that the Fed is ‘quantitatively tightening’ it is not just removing bank reserves. When the Fed sells X$ of securities as part of what it refers to as its balance-sheet normalisation program it removes X$ from bank reserves AND it removes X$ from the economy-wide money supply. In essence, it’s the process I described in the above-linked post (point 12) in reverse. That’s why the balance-sheet normalisation program is vastly more important, as far as monetary conditions are concerned, than the rate-hiking program.

[This blog post is an excerpt from a TSI commentary published about three weeks ago and covers a few general thoughts about what will happen in the financial world this year. Specific thoughts about what I expect this year from the stock, gold, bond, currency and commodity markets have also been included in TSI commentaries over the past three weeks.]

1) Early last year we predicted that the US stock market would experience greater-than-average volatility over the year ahead. This obviously happened, as there were more 2%+ single-day moves in the SPX during 2018 than in an average year.

We expect the same for this year, that is, we expect price volatility to remain elevated. The reason is that the two most likely scenarios involve abnormally-high price volatility. One of these scenarios is that a cyclical bear market began last October, and bear markets are characterised by periods of substantial weakness followed by rapid rebounds. The other scenario is that a very long-in-the-tooth cyclical bull market is about to embark on its final fling to the upside.

2) When attempting to predict when a period of economic growth will end it is futile to look more than 6-12 months into the future, because there are no leading recession indicators that can predict that far ahead with acceptable reliability. There are, however, leading indicators that can be used to determine the probability of a recession beginning within the next few quarters.

Early last year these indicators told us that a US recession would not begin during the first half of the year. They currently tell us that the US economy stands a good chance of commencing a recession this year, most likely during the second half of the year. Note, though, that if a recession does get underway this year it won’t become official until 2020, because recessions usually aren’t confirmed by the National Bureau of Economic Research until about 12 months after they start.

3) Regarding ‘cryptoassets’, at around this time last year we wrote:

“…it’s a good bet that the Bitcoin bubble reached its maximum level of inflation late last year. Also, the broader bubble in cryptoassets is set to burst during the first quarter of this year.”

And:

“By the end of 2018 it will be apparent that the public’s enthusiasm for Bitcoin and the “alt-coins” was one of history’s great speculative manias.”

This assessment looks correct.

We don’t have a strong opinion about what will happen to ‘cryptoassets’ in 2019. This is partly because there is no reasonable way to determine the fair value of these assets. For Bitcoin, for example, a price of $3,000 is no more or less sensible than a price of $30,000 or a price of $300.

Distributed ledgers can be very useful, but there should be ways to implement them without consuming a lot of resources. If so, the price of Bitcoin eventually will drop to almost zero.

A year ago we also predicted:

“Despite spectacular collapses in the prices of the popular ‘cryptoassets’ during 2018, central banks including the Fed and the ECB will firm-up plans to introduce their own blockchain-based currencies. This will be driven by a desire to eliminate physical cash, the thinking being that if there is no physical money it will be more difficult for the average person to make/receive unreported payments and escape a negative interest rate.”

As far as we know the major central banks didn’t firm-up plans to introduce their own blockchain-based currencies last year, but we continue to expect that they will — for the reasons mentioned above.

4) Regarding the Fed’s expected actions in 2018, early last year we wrote:

“Due to rising commodity prices it’s a good bet that “price inflation” will become a higher-profile issue during the first half of 2018, prompting the Fed to move ahead with its quantitative tightening (QT) and make two more rate hikes. However, both the QT and the rate-hiking will be put on hold during the second half of the year in reaction to increasing downside volatility in the stock market.”

We got the anticipated rate hikes during the first half and the increasing downside stock-market volatility during the second half of last year, but the Fed stuck to its guns. However, over the past three weeks the Fed Chairman has made it clear that the Fed will be quick to change direction if the stock market continues to decline and/or the economic numbers point to significant weakness.

For 2019 we expect one Fed rate hike, most likely in June. Also, we expect that people ‘in the know’ will explain to senior Fed members that it’s the balance-sheet reduction program (QT) that really counts, prompting the Fed to slow the pace of QT during the first half and conclude the QT program before year-end.

5) The ECB has just ended its QE program and has a tentative plan to implement its first rate hike during the third quarter of 2019. Given that nothing has been learned from the failed monetary experiments of the past few years, it’s a good bet that evidence of declining economic activity in the future will be met by the ramping-up or reintroduction of policies that failed in the past. Therefore, we predict that the ECB will not increase its targeted interest rates this year and will restart QE during the second half of the year.

6) This is not a prediction for 2019, but rather an observation that could apply for decades to come. We suspect that the age of real estate has ended.

We don’t mean that from now on it will be impossible to achieve good returns by investing in real estate, but that gone are the days when anyone could buy a house almost anywhere and likely end up with a sizable profit as long as they held for 10 years or more. From now on only astute investors will consistently make good returns from real estate, where “astute” means able to time the cyclical swings in the broad market or able to correctly anticipate future supply-demand imbalances in specific areas.

For the average person, residential property will transition from an investment to what it was prior to the 1970s: a consumer good (something bought solely for its use value).

The reason for the change is the interest-rate trend. The 3-4 decade downward trend in interest rates resulted in a 3-4 decade upward trend in housing affordability for buyers using debt-based leverage (that is, for the vast majority of buyers). There were corrections along the way, but provided that long-term interest rates continued to make lower lows there would eventually be a pool of new debt-financed buyers able to pay a much higher price.

There’s a good chance that the secular interest-rate trend reversed from down to up during 2016-2018. If so, future house buyers that don’t have good timing and/or substantial area-specific knowledge generally won’t make long-term capital gains on their residential property purchases.

The ‘true fundamentals’ began shifting in gold’s favour in October of last year and by early-December the fundamental backdrop was gold-bullish for the first time in almost a year. However, there is not yet confirmation of a new gold bull market from the most reliable indicator of gold’s major trend. I’m referring to the fact that the gold/SPX ratio is yet to achieve a weekly close above its 200-week MA. Here’s the relevant chart:

The significance of the gold/SPX ratio is based on the concept that the measuring stick is critical when determining whether something is in a bull market. If a measuring stick is losing value at a fast pace then almost everything will appear to be in a bull market relative to it. For example, pretty much everything in the world has been rising in value rapidly over the past few years when measured in terms of the Venezuelan bolivar. It should be obvious, though, that not everything can be simultaneously in a bull market. To determine which assets/investments are in a bull market we can’t only go by performance relative to any national currency; we must also look at the performances of assets/investments relative to each other.

That’s where the gold/SPX ratio comes in. Gold and the world’s most important equity index are effectively at opposite ends of the ‘investment seesaw’. Due to their respective natures, if one is in a long-term bull market then the other must be in a long-term bear market. In multi-year periods when they are both trending upward in dollar terms it means that the dollar is in a powerful bear market, not that gold and the SPX are simultaneously in bull markets.

An implication — as noted on the following chart — is that a gold bull market did not begin in December-2015. Gold cannot be in a bull market and at the same time be making new 10-year lows relative to the SPX, which is what it was doing until as recently as August-2018. At least, it can’t do that if a practical and sensible definition of “bull market” is used.

It’s possible that a gold bull market got underway in August-2018, but as mentioned above this has not yet been confirmed.

About five months ago I posted an article in response to stories that the Chinese government had pegged either the SDR-denominated gold price or the Yuan-denominated gold price. These stories were based on gold’s narrow trading range relative to the currency in question over the preceding two years, as if government manipulation were the only or the most plausible explanation for a narrow trading range in a global market. To illustrate the silliness of these stories I came up with my own story — that it was actually the Japanese government that was pegging the gold price. My story had, and still has, the advantage of being a better fit with the price data.

Just to recap, my story was that the Japanese government took control of the gold market in early-2014 and subsequently kept the Yen-denominated gold price at 137,000 +/- 5%. They lost control in early-2015 and again in early-2018, but in both cases they quickly brought the market back into line.

The following chart shows that they remain in control.

The narrow sideways range of the Yen gold price over the past 5 years is due to the Yen being the major currency to which gold has been most strongly correlated. The correlation is positive, meaning that the prices of gold and the Yen have a strong tendency to trend in the same direction. This is evidenced by the following daily chart, which compares the US$ price of gold with the US$ price of the Yen.

Moving from the fantasy world to the real world, the relationship depicted above doesn’t exist because the Japanese government is pegging gold to the Yen. It exists because both gold and the Yen trade like safe havens, meaning that they tend to do relatively well when economic growth expectations and the general desire to take-on risk are on the decline, and relatively poorly when economic growth expectations and the general desire to take-on risk are on the rise.

Gold trades like a safe haven because in part that’s what it is. The Yen is a piece of crap, but it trades like a safe haven due to the relentless popularity of Yen carry trades. These carry trades involve borrowing/shorting the Yen to finance long positions in higher-yielding currencies, and are a form of yield-chasing speculation. Periodically they have to be exited in a hurry to mitigate the losses caused by declining prices in the aforementioned high-yielding speculations. When this happens the Yen rallies, and sometimes the rallies are dramatic. Last week, for example.

Divergences or non-confirmations between gold and the Yen can create trading opportunities. However, the two markets are in line with each other at the moment, meaning that there is currently no divergence or non-confirmation worth trading.

The Fed probably will implement another 0.25% rate hike this week, but at the same time it probably will signal either an indefinite pause in its rate hiking or a slowing of its rate-hiking pace. The financial markets have already factored in such an outcome, in that the prices of Fed Funds Futures contracts reflect an expectation that there will be no more than one rate hike in 2019. However, this doesn’t imply that the Fed is about to stop or reduce the pace of its monetary tightening. In fact, there’s a good chance that the Fed unwittingly will maintain its current pace of tightening for many months to come.

The reason is that the extent of the official monetary tightening is not determined by the Fed’s rate hikes; it’s determined by what the Fed is doing to its balance sheet. If the Fed continues to reduce its balance sheet at the current pace of $50B/month then the rate at which monetary conditions are being tightened by the central bank will be unchanged, regardless of what happens to the official interest rate targets.

Another way of saying this is that a slowing or stopping of the Fed’s rate-hiking program will not imply an easier monetary stance on the part of the US central bank as long as the line on the following chart maintains a downward slope.

The chart shows the quantity of reserves held at the Fed by the commercial banking industry. A decline in reserves is not, in and of itself, indicative of monetary tightening, because bank reserves are not part of the economy’s money supply. However, when the Fed reduces bank reserves by selling securities to Primary Dealers (as is presently happening at the rate of $50B/month) it also removes money from the economy*.

I use the word “unwittingly” when referring to the likelihood of the Fed maintaining its current pace of tightening because, like most commentators on the financial markets and the economy, the decision-makers at the Fed are oblivious to what really counts when it comes to monetary conditions. They are labouring under the false impression that monetary tightening is effected mainly by hiking short-term interest rates and that the current balance-sheet reduction program is a procedural matter with relatively minor real-world consequences.

Therefore, over the next several weeks there could be a collective sigh of relief in the financial world as traders act as if the Fed has taken its foot off the monetary brake, followed by a collective shout of “oops!” when it becomes apparent that monetary conditions are still tightening.

*When the Fed sells X$ of securities to a Primary Dealer (PD) the effect is that X$ is removed from the PD’s account at a commercial bank and X$ is also removed from the reserves held at the Fed by the PD’s bank.

Apart from a 2-week period around the middle of the year, my Gold True Fundamentals Model (GTFM) has been bearish since mid-January 2018. There have been fluctuations along the way, but at no time since mid-January have the true fundamentals* been sustainably-supportive of the gold price. However, significant shifts occurred over the past fortnight and for the first time in quite a while the fundamental backdrop is now very close to turning gold-bullish. In fact, an argument could be made that it has already turned bullish.

Below is a chart comparing the GTFM (in blue) with the US$ gold price (in red).

The above chart understates the significance of the recent fundamental shift, because it appears that the GTFM has done no more than rise to the top of its recent range while remaining in bearish territory (which, of course, it has). However, a look beneath the surface at what’s happening to the GTFM’s seven individual components reveals some additional information.

The most important piece of additional information is the recent widening of credit spreads. The credit spreads input to the GTFM turned bullish four weeks ago, but since then it has moved a lot further into bullish territory. This has improved the fundamental situation (from gold’s perspective) without affecting the GTFM calculation.

Here is a chart showing the positive correlation between a measure of US credit spreads (the green line) and the gold/GNX ratio (gold relative to commodities in general). As economic confidence declines, credit spreads widen and gold strengthens relative to other commodities.

All things considered, for the first time in many months the true fundamentals appear to be slightly in gold’s favour. If the recent trend in the fundamental situation continues then we should see the gold price return to the $1300s early next year, but, of course, that’s a big if. Furthermore, even if the fundamental backdrop continues to shift in gold’s favour over the weeks ahead it will make sense for speculators who are long gold and the related mining equities to take money off the table when sentiment and/or momentum indicators issue warnings.

*Note that I use the term “true fundamentals” to distinguish the actual fundamental drivers of the gold price from the drivers that are regularly cited by gold-market analysts and commentators. According to many pontificators on the gold market, gold’s fundamentals include the volume of metal flowing into the inventories of gold ETFs, China’s gold imports, the volume of gold being transferred out of the Shanghai Futures Exchange inventory, the amount of “registered” gold at the COMEX, India’s monsoon and wedding seasons, jewellery demand, the amount of gold being bought/sold by various central banks, changes in mine production and scrap supply, and wild guesses regarding JP Morgan’s exposure to gold. These aren’t true fundamental price drivers. At best, they are distractions.

[This is an excerpt from a commentary posted at TSI about three weeks ago]

In an article titled “China’s monetary policy must change” Alasdair Macleod discusses a path that China’s government could take to make the Yuan gold-backed and thus bring about greater economic stability in China. Keith Weiner pointed out some flaws in the Macleod article, including the fact that the sort of Gold Standard that involves pegging a national currency to gold is just another government price-fixing scheme and therefore doomed to fail. We will single out an error in the article that Keith didn’t address and then briefly explain why a gold-backed Yuan is a pipe dream.

This excerpt from the article contains the error we want to focus on:

“China’s manufacturing economy will be particularly hard hit by the rise in interest rates that normally triggers a credit crisis. Higher interest rates turn previous capital investments in the production of goods into malinvestments, because the profit calculations based on lower interest rates and lower input prices become invalid.”

No, higher interest rates do not turn previous capital investments in the production of goods into malinvestments. A rise in interest rates can help reveal malinvestments for what they are, but it doesn’t create them.

Malinvestment occurs on a grand scale when the banking system creates a large amount of money out of nothing, generating false interest-rate signals and making it seem as if the amount of real savings in the economy is much greater than is actually the case. In response to the misleading (artificially low) interest rates and the increased future demand that these interest rates imply (more saving in the present implies more consumption in the future), investments are made in productive capacity. Many of these investments will prove to be ill-conceived, because future demand will turn out to be lower than expected. The investments only appeared to make sense due to the false impressions created by banks loaning copious quantities of new money into existence.

Another way to look at the situation is that a build-up of real savings requires a temporary reduction in consumption. Think of it as a savings-consumption trade-off. People abstain from consumption in the short term so that they will be able to consume more in the long term. When that happens on an economy-wide basis, interest rates move lower.

The falling interest rate indicates that savings are being increased and, by extension, that consumption will be higher in the future. In other words, the falling interest rate is a message that long-term investments in productive capacity are likely to pay off. The problem is that when money is created in large amounts out of nothing, interest rates tend to fall at the same time as consumption is increasing. So, entrepreneurs are being told (by the falling interest rate) that consumption will be greater in the future and to invest accordingly, but at the same time consumers are spending aggressively and ‘tapping themselves out’. Naturally, this doesn’t end well.

The crux of the matter is that malinvestment stems from artificially low interest rates. Also, once it has happened, it has happened. Rising interest rates can be part of the process via which the mistakes are revealed, but the mistakes won’t disappear if interest rates are prevented from rising. Putting it another way, it is not possible to avoid the painful consequences (economic recession or depression) that follow a period during which malinvestment was rife. This is relevant, because the Macleod article argues that interest rates could be kept low in China by linking the Yuan to gold and that by doing this the amount of existing investment that falls into the ‘mal’ category could be greatly reduced.

The reality is that regardless of what happens to interest rates in the future, the extent of the previous malinvestment is such that China’s economy will experience either a collapse or a very long period (probably at least a decade) of virtual stagnation. Given the control that the government has over the banking industry, we guess the latter.

The point is that linking the Yuan to gold wouldn’t be a way around the massive problems that are already baked into the cake. In any case this is a side issue, because there are two simpler reasons that the idea of a gold-backed Yuan is a non-starter.

The first reason is that in a world in which most international trades are US$-denominated, tying any currency apart from the US$ to gold would result in that currency’s exchange rate becoming as volatile as the US$ gold price. In fact, the exchange rate of the gold-backed currency would be totally determined by the performance of the US$ gold price. For example, if the US$ gold price were to rise by 20% in quick time then so would the exchange rate (against the US$) of the gold-backed currency.

The second and more important reason is that any government that implemented a Gold Standard would be relinquishing control of its currency. There would be no further scope for the manipulation of interest rates and currency exchange rates. Also, there no longer would be any scope for debt monetisation in particular and monetary stimulus in general. If we were to make an ordered list of the governments that are LEAST likely to give up these powers, China’s government would be at the top.

Summing up, linking the Yuan to gold would not prevent China’s economy from suffering the consequences of the widespread malinvestment of the past decade and probably would lead to much greater volatility in the prices of imports and exports. Most importantly, there is no way that the control freaks who lead the Communist Party of China are going to implement a monetary system that severely restricts their ability to intervene.