Blog 2 Columns

Like old soldiers, old beliefs never die. In the financial world, one of the many old beliefs that clings to life despite a pile of conflicting evidence is the one about gold being primarily a hedge against, or a play on, so-called “CPI inflation”.

The belief that big moves in the gold price are primarily driven by “price inflation” as measured by the CPI was spawned by what happened during 1972-1982. As illustrated by the following chart, there was a strong positive correlation between the gold price and the 12-month rate of change in the CPI during this period. However, it is clear that the positive correlation of 1972-1982 did not persist over the subsequent 37 years. In particular, the chart shows that the most recent two major rallies in the gold price (the rallies that began in early-2001 and late-2008) had nothing to do with “CPI inflation”. These rallies got underway in the midst of steep declines in the CPI’s growth rate and were at no time supported by a rapidly-rising CPI. The chart also shows that 2019′s significant up-move in the gold price had nothing to do with a rising rate of “CPI inflation”.

All substantial gold rallies are driven by falling confidence in the monetary authorities. The fall in confidence can be associated with so-called “price inflation”, but it certainly doesn’t have to be. As was the case with the major gold rallies that began in 2001 and 2008, it can be associated with stock market weakness, concerns about future economic growth, stresses in the banking system and minimal “price inflation”.

At some point within the next 10 years there could be a major bullish trend in the gold price that is linked to a large rise in the CPI, but that’s not the most likely scenario. There’s a better chance that the next major gold rally will be set in motion by a long-term trend reversal in the US stock market. In fact, even the gold bull market of the 1970s had more to do with a long-term bearish trend in US equities (the US stock market peaked in the late-1960s and bottomed in 1982) than rapid “price inflation”.

Naturally, the US$ gold price will rise over very long (50+ year) periods as the US$ depreciates, but so will the US$ prices of many other assets. Within this group of assets that tend to rise in terms of depreciating currency over the very long term, gold’s unique property is its counter-cyclicality. Gold racks up the bulk of its long-term appreciation during the bust phases of economic cycles.

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

During a gold bull market the “true fundamentals”, as indicated by our Gold True Fundamentals Model (GTFM), will be bullish most of the time. However, even during a bear market there can be periods of a year or longer when the fundamental backdrop is bullish most of the time. This means that the GTFM can’t be used to determine whether gold’s long-term trend is bullish or bearish. The historical sample size is small, but the most important prerequisite for the start of a gold bull market appears to be the start of a bear market in US equities.

That’s why we use a long-term weekly chart of the gold/SPX ratio with a 200-week MA to identify gold bull and bear markets. Unfortunately, at this time the chart (see below) is noncommittal, because gold/SPX bottomed in August of 2018 but is yet to make a sustained break above its 200-week MA. It’s possible that a gold bull market got underway in August of last year, but it’s also possible that we are dealing with a 1-2 year up-swing within a bear market.

The inverse long-term relationship between gold and the US stock market is not always evident over the short-term or even the intermediate-term, although over the past two years it does seem like the gold market and the stock market have been taking turns. This is illustrated by the following chart. The chart shows that there was a net gain in the SPX over the periods when gold trended downward and a net loss in the SPX over the periods when gold trended upward.

The implication is that gold’s next 3-month+ upward trend should unfold over a period in which the SPX generates a poor return (most likely a significant loss).

The following charts relate to an update on the markets that was just emailed to TSI subscribers.

1) Gold

2) The Gold Miners ETF (GDX)

3) The Yen

4) The S&P500 Index (SPX)

5) The Russell2000 ETF (IWM)

6) The Dow Transportation Average (TRAN)

7) The iShares 20+ Year Treasury ETF (TLT)

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

In one important respect, the average central banker is like the average politician. They both tend to focus on the direct and/or short-term effects and ignore the indirect and/or long-term effects of policies. In the case of the politician, this is understandable if not excusable. After all, the overriding concern of the average politician is winning the next election. The desire to be popular also influences the decisions of central bankers, but there is a deeper reason for the members of this group’s shortsightedness. The deeper reason is their unwavering commitment to Keynesian economic theory.

All central bankers are Keynesians at heart (if they weren’t they wouldn’t be central bankers), and Keynesian economic theory revolves around the short-term and the superficial. It’s all about policy-makers in the government and the central bank attempting to ‘manage’ the economy by stimulating demand under some conditions and dampening demand under other conditions, with the conditions determined by measures of current or past economic activity. For example, if certain statistics move an arbitrary distance in one direction then an attempt will be made to boost “aggregate demand”. That the concept of “aggregate demand” is bogus is never acknowledged, because acknowledging that the economy comprises millions of distinct individuals as opposed to an amorphous blob would call into question the entire basis for central control of money and interest rates.

In the short-term, the manipulation of money and interest rates often seems to work. In particular, pumping money and forcing interest rates below where they otherwise would be can lead to increased economic activity in the form of more consumption and more investment. What’s happening, however, is that false signals are causing people to make mistakes.

One problem is that people are incentivised by cheaper credit to consume more than they can afford, which guarantees reduced consumption in the future. The bigger problem, though, is on the investment front, in that projects and businesses that would not be financeable at free-market rates of interest are made to appear economically viable. This could seem like a very good thing for a while, but it means that a lot of resources get used in ventures that eventually will fail. It also means that the businesses that would have been viable in a non-manipulated rate environment suffer profit-margin compression due to the ability, created by the abundance of artificially-cheap credit, of relatively inefficient and/or unprofitable competitors to remain in operation.

In addition to the above, the persistent downward manipulation of interest rates leads to huge pension-fund deficits. However, burgeoning shortfalls in the world of pension funds is a major economic and political issue that deserves separate treatment and is outside the scope of this short discussion. Suffice to say right now that the massive unfunded pension liabilities that have arisen due to the policy of interest-rate suppression could be the excuse for new policies that are even more destructive, such as policies based on Modern Monetary Theory (MMT).

Summing up, the policy of interest-rate suppression promotes resource wastage and general profit-margin compression. It therefore reduces economic growth over the long term. Furthermore, it’s not so much that central bankers weigh the long-term cons against the short-term pros and opt for the latter; it’s that their chosen theoretical framework doesn’t even allow them to consider the long-term cons. That’s how the head of the ECB is able to argue with a straight face that even though euro-zone interest rates have been manipulated well into negative territory, more interest-rate suppression is needed to support the economy.

In a blog post in early-September I noted that the 10-year TIPS (Treasury Inflation Protected Security) yield had just gone negative and that the previous two times that this proxy for the real interest rate went negative (August-2011 and July-2016) the gold price was at an important peak. I then attempted to answer the question: If gold tends to benefit from a lower real interest rate, why would the gold price reverse downward shortly after the real interest rate turned negative?

In the earlier post I gave three reasons why a downward reversal in the gold price could coincide with the ‘real’ interest rate going negative. They were:

1) The dip into negative territory marked a low point for the real interest rate.

2) The real interest rate is just one of several fundamental gold-price drivers, so the upward pressure on the gold price exerted by a falling real interest rate could be counteracted by the downward pressure exerted by other fundamental influences.

3) The gold-bullish fundamental backdrop had been fully discounted by the current gold price.

At the time I thought that the third of the above-mentioned reasons may be applicable, because the speculative net-long position in Comex gold futures was very close to an all-time high and the weekly RSI (an intermediate-term momentum indicator) was almost as high as it ever gets.

As it turned out, the first and third reasons were applicable. Sentiment and momentum indicators pointed to extreme enthusiasm for gold on the part of the speculating community, and the following chart, which is an update of the chart included in the blog post linked above, shows that the 10-year TIPS yield reversed upward at the beginning of September.

The current situation is that neither sentiment nor fundamentals are conducive to substantial strength in the gold price. There could be a counter-trend rebound at any time, but the conditions are not right for a resumption of the major upward trend that got underway in the second half of last year.

In an earlier blog post I discussed the relationship between gold and inflation expectations. Contrary to popular opinion, gold tends to perform relatively poorly when inflation expectations are rising and relatively well when inflation expectations are falling.

The relationship outlined above is very clear on the following charts. The first chart shows that over the past 6 years there has been a strong positive correlation between RINF, an ETF designed to move in the same direction as the expected CPI, and the commodity/gold ratio (the S&P Spot Commodity Index divided by the US$ gold price). In other words, it shows that a broad basket of commodities has outperformed gold during periods when inflation expectations were rising and underperformed gold during periods when inflation expectations were falling. The second chart shows the same comparison over the past 12 months. Notice that inflation expectations bottomed for the year (to date) in mid-August and the commodity/gold ratio bottomed about two weeks later.

A large part of the reason for the strong inverse relationship between gold’s relative strength and inflation expectations is the general view that “inflation” of 2%-3% is not just normal, it is beneficial. In fact, most people have been conditioned to believe that it’s a serious economic problem necessitating draconian central bank intervention if money fails to lose purchasing power at a slow and steady pace.

Eventually the rate of “price inflation” will rise to a level where it starts being seen by the public as a major economic problem, and, as a result, the desire to maintain cash savings will enter a steep decline. It is at this point that the relationship depicted above will stop working and the demand for gold will begin to surge in parallel with rising inflation expectations. In other words, at some point the relationship depicted on the above chart will reverse due to declining confidence in the official money. This point probably will arrive within the next 10 years, but probably won’t arrive within the next 12 months. Over the next 12 months it’s likely that gold will continue to be favoured during periods of falling inflation expectations and other commodities will continue to be favoured during periods of rising inflation expectations.

So, if you think that the recent inflation-expectations bounce is the start of a trend then you should be looking for opportunities to increase your exposure to commodities such as oil and copper, not gold. My guess is that inflation expectations bottomed during August-October of this year, but I’m open to the possibility that the bottoming process will extend into early next year.

In a blog post on 30th September I noted that the banking sector (as represented by the US Bank Index – BKX) had begun to show relative strength, a ramification of which was that my Gold True Fundamentals Model (GTFM) had shifted from bullish to bearish. An update is warranted because the situation has changed since then in a way that is both interesting and a little surprising.

Just to recap, the relative performance of the banking sector (as indicated by the BKX/SPX ratio) is an input to my “true fundamentals” models for both the US stock market and the gold market, the difference being that when the input is bullish for one of these markets it is bearish for the other. In particular, relative weakness in the banking sector is considered to be bullish for gold and bearish for general equities.

As explained in the above-linked post, there was enough relative strength in the banking sector during the first half of September to flip the BKX/SPX input from gold-bullish to equity-bullish, causing the GTFM to shift from bullish to bearish. My guess at the time was that the GTFM would return to gold-bullish territory within the next two months, but I pointed out that it is usually better to base decisions on real-time information than on what might happen in the future.

Within a few days of my 30th September post the GTFM shifted back to bullish, where it remains today. This means that apart from a 3-week period during September, the fundamental backdrop has been supportive for gold since the beginning of this year. Refer to the following chart for more detail (the fundamental backdrop is gold-bullish when the blue line on the chart is above 50). Furthermore, there is evidence in the recent price action that gold’s correction is over. However, the fundamental and technical signs of strength in the gold market were not accompanied by signs of weakness in the banking sector.

What’s both interesting and a little surprising is that the renewed signs of strength in gold have gone hand-in-hand with additional signs of strength in the banking sector. Specifically, since my 30th September post the BKX has broken out to the upside (refer to the top section of the following weekly chart) and the BKX/SPX ratio has broken a sequence of declining tops that dates back to early last year (refer to the bottom section of the following chart).

The BKX/SPX ratio is just one of seven inputs to the GTFM, so there are circumstances in which the gold price can trend upward along with relative strength in the banking sector of the stock market. In other words, it isn’t out of the question that over the next few months we will get a gold rally in parallel with a continuing rise in the BKX/SPX ratio and strength in general equities. It’s more likely, however, that the emerging signs of strength in gold are warning of a short-term reversal to the downside in both the broad stock market and the banking sector.

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

Once an equity bear market is well underway it runs its course, regardless of the Fed’s actions. For example, the Fed started cutting interest rates in January of 2001, but the bear market that began in March of 2000 continued until October-2002. For another example, the Fed started cutting interest rates in September-2007, but a bear market commenced in October-2007 and continued until March-2009 despite numerous Fed actions designed to halt the price decline. On this basis it can be argued that the Fed’s introduction of a new asset monetisation program roughly one week ago won’t prevent the stock market from rolling over into a major bearish trend. However, there is a good reason to think that it could be different this time (dangerous words, we know) and that the Fed’s new money-pumping scheme will prove to be game-changer.

The reason to think that it could be different this time is that in one respect it definitely is different. We are referring to the fact that although the Fed started cutting interest rates in the early parts of the last two cyclical bear markets (2000-2002 and 2007-2009), it didn’t begin to directly add new money to the financial markets until the S&P500 Index had been trending downward with conviction for about 12 months.

To further explain, when the Fed’s targeted interest rates follow market interest rates downward, which is what tends to happen during at least the first half of an economic downturn, the official rate cuts do not add any liquidity to the financial system. It’s only after the Fed begins to pump new money into the financial markets that its actions have the potential to support asset prices.

During the last two bear markets, by the time the Fed started to pump money it was too late to avoid a massive price decline. This time around, however, the Fed has introduced a fairly aggressive money-pumping program while the S&P500 is very close to its all-time high and seemingly still in a bullish trend.

The Fed has emphasised that the new asset monetisation program should not be called “QE” because it does not constitute a shift in monetary policy. Technically this is correct, but in a way it’s worse than a shift towards easier monetary policy. The Fed’s new program is actually a thinly-disguised attempt to help the Primary Dealers absorb an increasing supply of US Treasury debt. To put it another way, the Fed is now monetising assets for the purpose of financing the US federal government, albeit in a surreptitious manner.

This relates to a point we made in a recent blog post. The point is that when the central bank is perceived to be financing the government, as opposed to implementing monetary policy to achieve economic (non-political) objectives such as “price stability”, there is a heightened risk that a large decline in monetary confidence will be set in motion. One effect of this would be an increase in what most people think of as “inflation”.

Summing up, it’s possible that the Fed’s new asset monetisation program will extend the current cycle (prolong the equity bull market) and lead to more “price inflation” than earlier programs.