Blog 2 Columns

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

It is estimated that about 50% of the production costs of the average gold miner are linked to energy. That’s why the gold/oil ratio is a reasonable proxy for the average profit margin across the gold mining industry.

The gold/oil ratio peaked in April of this year and then plunged. Refer to the following chart for the details. It’s a good bet that the April-2020 peak was the major (long-term) variety since it was driven by a spectacular collapse in the oil price that almost certainly won’t be repeated within the next few years. This implies that the industry-wide gold mining profit margin peaked on a long-term basis during the first half of this year.

For two reasons, the high probability that the gold/oil ratio peaked on a long-term basis 5-6 months ago is not bearish for gold mining stocks.

The first reason is that the plunge in the gold/oil ratio from its April-2020 peak ended with the ratio at a multi-decade high. In other words, by historical standards the gold price is still very high relative to the cost of energy, meaning that gold mining profit margins remain elevated. That’s why we expect the gold mining indices/ETFs to trade at much higher levels within the next 12 months.

The second reason is that when the gold/oil ratio retains about half of its gain from a major low (in this case in 2018) to a major high, which it has done to date, the time from a major gold/oil ratio peak to a major gold mining peak tends to be 1.5-2.5 years. This implies that the cyclical advance in the gold mining sector that began in 2018 won’t end before the second half of 2021, although be aware that a sustained move below 40 in the gold/oil ratio would warn a multi-year peak was either in place or close.

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

The 4-8 year period beginning in February of this year potentially will contain three or more official recessions and come to be referred to as the Depression of the 2020s. If so, unlike the Depression of the 1930s the Depression of the 2020s will be inflationary.

The Depression of the 1930s was deflationary in every sense of the word, but the primary cause of the deflation was the performance of the money supply. We don’t have the data to calculate True Money Supply (TMS) during the 1930s, but we have the following chart showing what happened to the M1 and M2 monetary aggregates from 1920 to 1953. The chart shows that there was a substantial contraction in the US money supply during 1929-1933 and that the money supply was no higher in 1938 than it had been at the start of the decade.

Clearly, the money-supply situation today could not be more different from the money-supply situation during the early-1930s*.

One reason for the difference is that during the 1930s the Fed was restricted by the Gold Standard. The Gold Standard was diluted in 1933, but throughout the 1930s the US$ was tethered to gold.

The final official link between the US$ and gold was removed in 1971. This made it possible for the Fed to do a lot more, but as far as we can tell the Fed actually didn’t do a lot more in the 1990s than it did in the 1960s. It has been just the past 20 years, and especially the past 12 years, that the Fed has transmogrified from an institution that meddles with overnight interest rates and bank reserves to a central planning agency that attempts to micro-manage the financial markets and the economy. After history’s greatest-ever mission creep, it now seems that there is nothing associated with the financial markets and the economy that is outside the Fed’s purview.

In parallel with the expansion of the Fed’s powers and mission there emerged the idea that for a healthy economy the currency must lose purchasing power at the rate of around 2% per year. This idea has come to dominate the thinking of central bankers, but it has never been justified using logic and sound economic premises. Instead, when asked why the currency must depreciate by 2% per year, a central banker will say something along the lines of: “If the inflation rate drops well below 2% then it becomes more difficult for us to implement monetary policy.”

As an aside, because of the way the Fed measures “inflation”, for the Fed to achieve its 2% “inflation” target the average American’s cost of living probably has to increase by at least 5% per year.

Due to the central-banking world’s unshakeable belief that money must continually lose purchasing power and the current authority of the central bank to do whatever it takes to achieve its far-reaching goals, the greater the perceived threat of deflation the more monetary inflation there will be. We saw an example of this during 2001-2002 and again during 2008-2009, but 2020 has been the best example yet. The quantity of US dollars created since the start of this year is greater than the entire US money supply in 2002.

It actually would be positive if deflation were the high-probability outcome that many analysts/commentators claim it is, because deflation is relatively easy to prepare for and because 1-2 years of severe deflation would set the stage for strong long-term growth. However, one of today’s dominant driving forces is the avoidance of short-term pain regardless of long-term cost, so there will be nothing but inflation until inflation is perceived to be the source of the greatest short-term pain. This doesn’t mean that a depression will be sidestepped or even postponed. What it means is that the next depression — which may have already begun — will be the inflationary kind.

*US True Money Supply (TMS) has expanded by 35% over the past 12 months.

Since the Fed implemented its first Quantitative Easing (QE) program in 2008-2009, many analysts have claimed that QE adds to bank reserves but does not increase the money supply (bank reserves aren’t counted in the money supply). Such claims are patently wrong.

Anyone who bothered to do some basic calculations would see that when the Fed monetises securities, as it does when implementing QE, it adds to the economy-wide supply of money. Specifically, if you add-up the increases in the dollar amounts of demand and savings deposits within the commercial banking system during a period in which the Fed ran a QE program and subtract from this the amount of money loaned into existence during the period by commercial banks, you will find that the difference is approximately equal to the net dollar value of securities purchased by the Fed.

The fact is that when the Fed buys X dollars of securities from a Primary Dealer (PD), either as part of a QE program or a non-QE open market operation, it adds X dollars to the PD’s deposit at a commercial bank AND it adds X dollars to the reserve account at the Fed of the PD’s bank. Another way to look at the situation is that the Fed’s purchases of securities add covered money (money in commercial bank deposits covered by reserves at the Fed) to the economy.

The process is described at the top of page 6 in the Fed document linked HERE. Some parts of this document are out of date in that it was written well before the Fed started paying interest on reserves and before commercial banks were able to reduce their required reserve amounts to zero via the process called “sweeping”, but the mechanics of the Fed’s direct money creation haven’t changed.

The persistent claims that the Fed’s QE doesn’t boost the money supply are not only wrong, but also dangerous. The creation of money out of nothing distorts relative prices, leading to mal-investment and slower economic progress. Consequently, the failure to identify the direct link between QE and money-supply growth makes the QE seem far less harmful than is actually the case.

[This blog post is an excerpt from a recent TSI commentary, with updated charts and minor modifications]

As is the case with the natural gas price, the price of the S&P Agricultural Index (GKX) appears to have made a cycle low via a double bottom in April and June of this year. At this stage the rebound from the Q2-2020 bottom doesn’t look more significant than any of the other rebounds of the past five years (see chart below), but the combination of rampant monetary inflation, rising inflation expectations and increasingly-volatile weather due to natural climate cycles is the recipe for a much longer and larger rally.

For at least the past 12 months we have argued that owning the stocks of fertiliser producers such as Mosaic (MOS) and Nutrien (NTR) is the best way for most people to participate in the agricultural (‘ag’) commodities bull market that potentially will unfold during 2020-2022. That continues to be our view. Although the fertiliser producers only provide indirect exposure to rising prices for ag commodities, obtaining direct exposure via the stock market involves owning ETFs that usually suffer substantial value leakage due to the “futures roll”.

The following daily charts show that the aforementioned stocks have rebounded strongly from their March-2020 lows but remain well below their highs of the past 12 months.

Not evident on the above daily charts is the fact that MOS and NTR are trading at small fractions of their 2008 peaks. The following weekly charts provide some additional perspective.

We think that the risk/reward ratios of these stocks are roughly equivalent, with NTR being less risky and MOS offering greater leverage. Both companies were very profitable in the June-2020 quarter and should become even more profitable over the quarters/years ahead.

[This blog post is an excerpt from a TSI commentary published within the past two weeks]

Many analysts downplay the Fed’s influence on bond yields, but we don’t think it’s possible to explain the following chart without reference to the massive yield-suppressing boot of the Fed. The chart compares the 10-year T-Note yield with the 10-Year Breakeven Rate, a measure of the market’s inflation (CPI) expectations. The Breakeven Rate is calculated by subtracting the Treasury Inflation Protected Security (TIPS) yield from the associated nominal yield.

The chart reveals that the 10-year T-Note yield generally moves in the same direction as the 10-Year Breakeven Rate. This is hardly surprising, given that the expected “inflation” rate is usually the most important determinant of the long-term interest rate. In particular, a higher expected “inflation” rate usually will result in a higher long-term interest rate. However, something very strange has happened since March of 2020. Since that time there has been a large rise in the expected CPI while the nominal 10-year yield has drifted sideways near its all-time low.

As far as we can tell, there are only two ways that the sort of divergence witnessed over the past five months between inflation expectations and nominal bond yields could come about.

One way is capital flight from outside the US to the perceived safety of the US Treasury market that overrides other effects on bond prices/yields. This is what happened during 2011-2012, which is the only other time that a substantial rise in inflation expectations coincided with flat or declining nominal US bond yields. In 2011-2012, capital flight to the US was prompted by the euro-zone’s sovereign debt crisis.

Manipulation by the Fed is the other way that the divergence could arise.

Over the past five months there has been no evidence of capital flight to the US. Therefore, it’s clear that the Fed has maintained sufficient pressure to prevent the nominal 10-year bond yield from responding in the normal way to a large rise in the bond market’s inflation expectations. Not without ramifications, though.

A large rise in the expected “inflation” rate in parallel with a flat nominal interest rate equates to a large decline in the ‘real’ interest rate. In this case, it equates to the ‘real’ US 10-year interest rate moving well into negative territory. This has put irresistible downward pressure on the US$ and irresistible upward pressure on the prices of most things that are priced in dollars, including gold, equities, commodities and houses. It has even put upward pressure on the price of labour, despite the highest unemployment rate since the 1930s.

At the moment the Fed undoubtedly is pleased with its handiwork. The rise in the gold price to new all-time highs could be viewed as a rebuke, but these days no-one in the world of central banking cares about the gold price. Central bankers do, however, care about the stock market, and the Fed’s governors will be patting themselves on the back for having helped the S&P500 Index fully retrace its February-March crash. They also will be pleased that the CPI is rising in spite of the deflationary pressures resulting from the lockdowns. After all, the concerns they have expressed over the years about insufficient “inflation” make it clear that the last thing they want is for your cost of living to go down*.

However, the Fed is ‘playing with fire’. Putting aside the long-term negative economic consequences of the mal-investment caused by the Fed’s money pumping and interest-rate suppression, if the Fed continues to prevent bond yields from reflecting rising inflation expectations then the steady shift currently underway towards hard assets and anything else that offers protection against currency depreciation will become a stampede. And once that happens, the sort of central-bank action that would be required to restore confidence would crash both the stock market and the economy.

If the Fed continues along its current path then an out-of-control rise in prices won’t be an issue to be dealt with in the distant future. It possibly will become an issue before the end of this year and very likely will become an issue by the middle of next year.

*Nobody with common-sense can figure out why.

[This is an excerpt from a commentary published at TSI on 16th August 2020. The message remains applicable.]

The US$ commenced a cyclical decline in March of this year and probably will trade well below current levels during the first half of 2021. From the perspective of our investing and trading, the main consequences of this weakness in the senior currency are:

1) Broad-based strength in the commodity markets. As illustrated below, the S&P Spot Commodity Index (GNX) has been trending upward since shortly after the US$ peaked.

2) Strength in emerging market equities, especially the equities that are based in emerging economies that rely heavily on commodity exports. For example, Brazilian equities. Despite the debilitating effects on Brazil’s economy of virus-related lockdowns, the following chart shows that the iShares Brazil ETF (EWZ) has done well since the US$ began trending downward.

Note that it could make sense to buy EWZ if there’s a pullback to US$26-$28 within the next several weeks.

3) Rising US inflation expectations. As illustrated below, the US 5-Year Breakeven Rate (the annual CPI increase that the market expects the US government to report over the next few years) has been trending upward since the US$ peaked.

The above consequences have been apparent over the past few months and should become more pronounced within the next 12 months, especially during the first half of next year. However, we think that in the short-term the focus of investors/speculators should be on the potential for a US$ rebound.

It’s possible that the Dollar Index (DX) will become more stretched to the downside before it commences a meaningful countertrend rally, but once a US$ rebound begins in earnest the prices that have been elevated over the past few months by US$ weakness, which means the prices of almost everything, will fall.

It does not make sense to exit all anti-US$ trades in anticipation of a short-term US$ rally. Doing so would be risky because these trades would make large additional gains if the US$ rebound were to be postponed for a month or two. Also, making a complete exit would create the problem of having to time the re-entry. However, it would make sense to hedge against a short-term US$ recovery while maintaining core exposure in line with the dollar’s longer-term weakening trend.

Gold market sentiment is complicated at the moment. There are signs of speculative froth, but at the same time the total speculator net-long position in Comex gold futures is close to its low for the year despite the US$ gold price recently hitting an all-time high. A likely explanation is that large speculators are focusing more on gold ETFs than on gold futures.

The price of a gold ETF that holds physical gold will track the gold price automatically. Therefore, there never will be an increase in the amount of gold held by such an ETF unless bullish speculators become sufficiently enthusiastic to push the market price of the ETF above its net asset value (NAV). When this happens it creates an arbitrage opportunity for the ETF’s Authorised Participants (APs), which results in the addition of gold bullion to the ETF’s inventory.

The following charts from http://www.goldchartsrus.com/ show large gains in the amounts of physical gold held by GLD and IAU, the two most popular gold ETFs. Specifically, the charts show that about 400 tonnes (12M ounces) of gold was added to the combined GLD-IAU inventory over the past few months. This actually isn’t a huge amount within the context of the global gold market, but it points to aggressive buying of the ETFs.

In other words, the evidence of gold-related speculative froth is in the stock market rather than the futures market.

The next chart shows that the silver story is similar. Specifically, the chart shows that about 7,000 tonnes (220M ounces) of physical silver have been added to the inventory of the iShares Silver ETF (SLV) since the March-2020 price low, including about 1,900 tonnes (60M ounces) during the three-week period culminating at the early-August price high.

The fundamental backdrop remains supportive for gold and silver, but sentiment suggests that a multi-month price top was put in place in early-August or will be put in place via a final spike within the next three weeks.

Many things have happened in 2020 that have never happened before, so in some respects it certainly is different this time. The most important of these differences, four of which are discussed below, revolve around the policy responses to the COVID-19 pandemic.

In the context of human history and in terms of the amount of death that it has caused, the COVID-19 pandemic is not particularly unusual. On average, there have been about two major pandemics every hundred years going back several centuries. Over the past hundred or so years, for example, there was the “Spanish Flu” in 1918 and the “Asian Flu” in 1958. Almost everyone has heard about the Spanish Flu and its horrific death toll, but the Asian Flu is less well known. Suffice to say that the death toll per million of global population resulting from the Asian Flu was about four times the current death toll per million of global population resulting from COVID-19.

The big difference this time is not the disease itself but the reaction to the disease. In particular, never before have large sections of the economy been shuttered by the government in an effort to limit the spread of the disease. Now, however, it has become accepted practice that as soon as the number of COVID-19 cases in an area moves beyond an unspecified low level, the orders go out for many businesses to close and for the public to stay home.

If locking down large sections of the economy is the optimal response to a pandemic, why wasn’t it tried before? Why did it take until 2020 to figure this out?

The answer is associated with the fact that COVID-19 is the first major pandemic to strike under the monetary system that came into being in the early-1970s. Under this system there is no limit, except perhaps an arbitrary level of increase in an arbitrary indicator of “inflation”, to the amount of money that can be created out of nothing. Previously there were limits to money creation imposed by some form of gold standard.

If there were rigid limits to the supply of money, the sort of economic lockdown implemented by many governments this year would cause immediate and extreme hardship to the majority of people. Therefore, it wouldn’t be an option. It is an option today because the ability to create an unlimited amount of money out of nothing presents the opportunity for the government to alleviate, or even to completely eliminate, any short-term pain for the majority of people. It should be obvious that this is an exchange of short-term pain for greater pain in the long-term, but hardly anyone is thinking about the long-term. In fact, the short-term fix that involves showering the populace with money is being advocated as if it didn’t have huge long-term costs.

Another difference between the current pandemic and earlier pandemics is the availability of information. For the first time ever during a major pandemic, almost everyone has up-to-the-minute data regarding the number of cases, hospitalisations and deaths. The widespread fixation on the cases/deaths data has fostered the general belief that getting the numbers down takes precedence over everything, long-term consequences be damned.

The third difference is linked to the first difference, that is, to the ability to create an unlimited amount of money out of nothing. This ability has existed for almost half a century, but 2020 is the first time it has been used by the government to provide money directly to the public. Prior to this year it was used exclusively by the central bank to manipulate interest rates and prop-up prices in financial markets. A consequence WILL be much more traditional “inflation” next year than has occurred at any time over the past decade.

The fourth and final difference that I’ll mention today is also linked to the money-creation power. It is that in 2020 some developed-world governments, most notably the US government, have stopped pretending to be concerned about their own indebtedness. Previously they made noises about prudently managing deficits and debts, as if the debt eventually would have to be repaid. However, this year they have tacitly acknowledged the reality that there has never been any intention to pay off the debt, and, therefore, that the debt can expand ad infinitum.

2020 certainly has been a watershed year.