Blog 2 Columns

Over the past few years there has been a lot of irrational fear-mongering within the gold commentariat regarding the potential for the Comex to default due to having insufficient physical gold in its coffers. I most recently addressed this topic in a post on 6th May.

I’m not going to repeat all the information contained in earlier posts such as the one linked above. However, here’s a very brief recap:

1) The ratio of Comex Open Interest (OI) to “Registered” gold inventory that Zero Hedge et al employed to create the impression of high default risk was not, in any way, shape or form, a valid indicator of such risk.

2) The amount of gold available for delivery at any time is the TOTAL amount of gold in the “Registered” and “Eligible” categories, not just the amount of “Registered” gold, since it is a quick and easy process to convert between “Eligible” and “Registered”.

3) The maximum amount of gold that can be demanded for delivery is the amount of OI in the nearest futures contract, not the total OI across all futures contracts.

In the above-linked post I included a chart showing that the amount of gold delivered to futures ‘longs’ over the preceding two years was much less in both absolute and relative terms than at any other time over the past decade. The chart made it clear that as the gold price fell, the desire of futures traders to ‘stop’ a contract and take delivery of physical gold also fell.

This meant that the unusually-small amount of gold in the “Registered” category was almost certainly related to an unusually-low desire on the part of futures ‘longs’ to take delivery. To put it another way, the unusually-small amount of gold in the “Registered” category was nothing more than a natural consequence of bearish sentiment.

Here was my conclusion at that time:

“It’s a good bet that if a multi-year gold rally began last December (I think it did) then the desire to take delivery will increase over the next couple of years, prompting a larger amount of gold to be held in the Registered category.”

Finally, here are charts from goldchartsrus.com showing that this year’s strength in the gold price led to 1) an increase in the desire of futures ‘longs’ to take delivery and 2) a related and substantial increase in the amount of “Registered” gold.

Exactly as expected.

Here is an excerpt from a recent TSI commentary.

Despite the popularity of doing so, subtracting the percentage change in the CPI or some other price index from the current nominal interest rate will not result in a realistic or reasonable estimate of the current ‘real’ interest rate.

The method of real interest rate calculation summarised above is wrong in two different ways, each of which is sufficient to render the result invalid. The first and most obvious way it is wrong is that the CPI does not reflect the change in the purchasing power of money. This is not just because it has been re-jigged over the decades as part of an effort to minimise its value, but also because the entire concept of a “general price level” is nonsense. There is no such thing as a general price level because disparate items cannot be averaged. To explain by way of a simple example, averaging the prices of a car, a potato and a visit to the dentist makes no more sense than averaging the goods/services themselves. Clearly, a car, a potato and a visit to the dentist cannot be averaged.

However, even if, for the sake of argument, we assume that the CPI makes sense at a conceptual level and is a satisfactory estimate of the change in the purchasing power of money, we still couldn’t use it to determine the current real interest rate. The reason is that the real rate of return obtained from an interest-producing investment has nothing to do with the historical change in the purchasing power of money and everything to do with the amount by which the purchasing power of money will change in the future. For example, if you buy a 1-year bond today your real return will be determined by how much the purchasing power of money changes over the next 12 months; not by how much it changed over the previous 12 months.

So, when you see a chart showing the nominal interest rate minus the 12-month percentage change in the CPI, what you are looking at is NOT a chart of the real interest rate.

How, then, should the real interest rate be calculated and charted?

The hard reality is that there are some things worth measuring that simply can’t be measured. The real interest rate falls into this category. By taking into account money-supply growth and population growth and by making a guess regarding productivity growth it is possible to come up with a realistic, albeit very rough, estimate of how the purchasing power of money shifted over a long historical period, but it will never be possible to calculate the current real interest rate.

The best we can do is use the financial market’s average forecast regarding the future CPI in our calculations. In other words, the best we can do is use the TIPS (Treasury Inflation Protected Security) yield as a proxy for the real interest rate, since the TIPS yield is effectively the nominal yield minus the expected CPI. A chart of the 5-year TIPS yield is displayed below and discussed in the next section (in relation to gold).

The TIPS yield is not an accurate reflection of the real interest rate because it is based on the CPI and because the market’s expectations are sometimes wrong, but for practical speculation purposes it seems to be good enough.

Here are a few aspects of the current financial situation that I find interesting:

1) The spread between the 10-year T-Note yield and the 2-year T-Note yield is a proxy for the US yield curve. When this yield-spread is widening it implies that the yield curve is steepening and when this yield-spread is narrowing it implies that the yield curve is flattening.

The following chart shows that the 10yr-2yr yield-spread broke above its September high late last week. This is evidence that the US yield curve has shifted from a flattening to a steepening trend, which is a recession warning and a bearish omen for the US stock market. It is also bullish for gold, although the overall fundamental backdrop is no better than neutral for gold.

2) As illustrated below, the Dollar Index has been oscillating within a horizontal range for about 20 months. It has worked its way upwards since May of this year, but is roughly unchanged since the beginning of the year and is about 2 points below the top of its 20-month range.

The fact that the Dollar Index is roughly unchanged since the start of this year is interesting because the dominant fundamental driver of intermediate-term trends in the US dollar’s exchange rate (the relative strength of the US stock market) has been US$-bullish throughout this year. By rights, the Dollar Index should be well above its current level.

There are two reasons that the Dollar Index is still trapped within its horizontal range. One is that there was a huge sentiment-driven overshoot to the upside during the first quarter of 2015. The other is mentioned below.

3) The following chart shows the Treasury securities held in custody at the Fed for foreign central banks (FCBs). Not all US government debt securities owned by FCBs are held at the Fed, but more than half of them are and trends in the Fed’s custody holdings should reflect trends in overall holdings.

The chart shows that FCBs stopped being net buyers of US government debt in December-2013 and have been relentless net-sellers since December of last year. This tells us that FCBs have made a concerted attempt over the past 10 months to weaken the US$. This, I suspect, is a reason that the Dollar Index has remained range-bound this year to date despite the upward pressure exerted by US$-bullish fundamentals.

4) The following chart shows the amount of money held in the US federal government’s account at the Fed. Prior to the past year or so the amount of money in the Treasury’s deposit at the Fed was usually below $100B and had never been more than $200B, but something changed in November of 2015.

Since early-November of 2015 there has been a net addition of about $400B to the Treasury’s account at the Fed. This means that the Treasury has temporarily withdrawn about $400B from the US economy over the past 12 months, an action that is, in effect, a monetary tightening. This action would undoubtedly have slowed the pace of US economic activity.

The Treasury is obviously not trying to reduce the pace of economic activity. Why would it, especially in the lead-up to an election? It is, instead, trying to build-up a larger cash buffer for risk management purposes, possibly in expectation of more inter-party haggling over the debt ceiling.

5) The final chart shows that the S&P500 Index is precariously poised near a technical precipice. A downside breakout will probably soon happen, but until support at 2120 is decisively breached there will be an outside chance of a rise to new highs prior to a tradable decline.

I’ve seen a lot of commentary in which the author assumes that this year’s rally in the gold price is the first rally in a new cyclical bull market. It probably is, but at this stage — as the saying goes — the jury is still out. At this stage it’s best to reserve judgment, because blindly assuming something that might not be true can lead to large losses.

There are two main reasons that ‘the jury is still out’. First and foremost, at no time over the past 12 months have gold’s true fundamentals* been definitively bullish. Instead, they have oscillated around neutral. There have been periods, such as February-April of this year, during which the fundamentals had a bullish skew, but after tipping in the bullish direction for at most 3 months they have always tipped in the other direction for a while.

Considering what central banks have been doing to the official forms of money my statement that the fundamental backdrop is not definitively gold-bullish could seem strange. After all, the ECB is firmly committed to asset monetisation and negative interest rates based on the belief that these counter-productive policies are working, and the Federal Reserve is seemingly afraid to take even a small step towards “policy normalisation” despite its targets for employment and “inflation” having been reached more than three years ago. However, gold’s fundamentals are determined by confidence, not by sound principles of economics. To put it another way, whether the fundamental backdrop is bullish or bearish for gold is determined by the general perception of what’s happening on the economic and monetary fronts rather than what’s actually happening. Perception will eventually move into line with reality, but in the meantime years can go by.

Since early-July the true fundamentals have been neutral at best and over the past month they have, on balance, been slightly bearish. However, they are constantly in flux and it currently wouldn’t take much to shift them to bullish or make them definitively bearish. In particular, two of the most important fundamental drivers of the gold price are neutral and positioned in a way that they could soon shift decisively in one direction or the other. I’m referring to the real interest rate, as indicated on the first of the following charts by the reciprocal of the TIPS bond ETF (1/TIP), and the US yield curve, as indicated on the second of the following charts by the 10yr-2yr yield spread.

The real interest rate would turn decisively gold-bullish if 1/TIP were to break downward from its recent 4-month range and decisively gold-bearish if 1/TIP were to break upward from its recent 4-month range. The yield curve, which has been gold-bearish for the bulk of the past three years, would turn decisively gold-bullish if the 10yr-2yr yield spread were to break solidly above its September high. Note that it is very close to doing exactly that. As an aside, a break by the 10yr-2yr yield spread above its September high would also be a recession warning and a bearish omen for the stock market.

The price action is the other reason for the uncertainty as to whether this year’s rally marked the start of a cyclical bull market. I’m referring to the fact that of all the rallies in gold and the gold-mining indices from multi-year lows, this year’s rally is most similar to the bear-market rebound of 1982-1983.

The gold rally that began in December of 2015 will differentiate itself from the 1982-1983 bear-market rebound if the gold price closes above its July-2016 peak AND the HUI closes above its August-2016 peak.

Fortunately, you don’t need to be a fervent believer in the ‘new gold bull market’ story to make money from the rallies in gold and gold stocks. You will just tend to be more cautious than the bulls with blind faith.

*Five of the six “true fundamentals” were mentioned in the September-2015 TSI blog post linked HERE. The sixth is the general trend in commodity prices as indicated by a broad-based commodity index such as GNX.

All else remaining equal, an increase in the supply of money will lead to a decrease in the purchasing-power (price) of money. Furthermore, this is the only effect of monetary inflation that the average economist or central banker cares about. Increases in the money supply are therefore generally considered to be harmless or even beneficial as long as the purchasing-power of money is perceived to be fairly stable*. However, reduced purchasing-power for money is not the most important adverse effect of monetary inflation.

If an increase in the supply of money led to a proportional shift in prices throughout the economy then its consequences would be both easy to see and not particularly troublesome. Unfortunately, that’s not the way it happens. What actually happens is that monetary inflation causes changes in relative prices, with the spending of the first recipients of the newly-created money determining the prices that rise the first and the most.

Changes in relative prices generate signals that direct investment. The further these signals are from reality, that is, the more these signals are distorted by the creation of new money, the more investing errors there will be and the less productive the economy will become.

Also, although adding to the money supply cannot possibly increase the economy-wide level of savings, monetary inflation temporarily creates the impression that there are more savings than is actually the case. This reduces interest rates, which prompts investments in ventures that are predicated on unrealistic forecasts of future consumer spending. Again, the eventual result will be a less productive economy.

During any given year it usually won’t be possible to separate-out the pernicious effects of monetary inflation and the distortion of interest rates that goes hand-in-hand with it from all the other forces affecting the economy. There will simply be too many things going on in the world that could be influencing the data. However, by taking a wide-angle (that is, long term) view it will often be possible to see the effects on the economy of shifts in monetary inflation.

As an example of how long-term shifts in monetary inflation/intervention can be linked to long-term shifts in economic progress I present the following chart of the US Industrial Production Index. The chart shows that the industrial-production growth trend flattened at around the time that the ‘golden shackles’ were removed, that is, at around the time that the Fed was essentially empowered to do a lot more. This is not a fluke. The chart also shows that the ramping-up of the Fed’s monetary interventions in 2008-2009 has been followed by the weakest post-recession recovery in at least 70 years. Again, this is not a fluke.

In economics, to have a chance of correctly interpreting cause and effect in the data you first have to know the right theory. That’s why Keynesian economists will not link the US industrial production slowdown with the Fed’s increasingly aggressive monetary interventions. From their perspective, the only negative effect that monetary inflation can possibly have is to make the cost of living rise at a faster pace than they believe it should be rising.

*Stable, here, means rising at around 2% per year. Note that it is not possible to come up with a single number that represents the economy-wide purchasing power of money, but this doesn’t stop the government (and some private organisations and individuals) from doing exactly that.

Not surprisingly, one of the silliest explanations for last week’s sharp decline in the gold price appeared in an article posted at the Zero Hedge web site. According to this article, the only plausible explanation for the decline is rampant manipulation while China’s markets were closed for the “Golden Week” public holidays*.

In an effort to prove that manipulators in the West routinely take advantage of China’s markets being closed to suppress the gold price, the article includes charts covering the 2015 and 2014 “Golden Week” holiday periods. These charts suggest that, as was the case this year, the gold price tanked during each of the preceding two years when China was closed for business. However, the charts are very misleading. Deliberately so, in my opinion.

For example, the following chart from the article suggests that the gold price plunged from the $1140s to around $1105 during the 2015 “Golden Week” holidays and then quickly recouped its losses after China’s markets re-opened, but that’s not the case. The “Golden Week” is from 1st to 7th October every year, so what actually happened was that the gold price fell from the $1140′s down to around $1115 during the days leading up to the 2015 “Golden Week” (while China was open for business) and then rebounded to the $1140s while China was on holiday.

During the 2014 “Golden Week” holiday period there was no net change in the gold price.

The belief that manipulation is the be-all-and-end-all of the gold market is based on two false premises. The first is that the fundamentals are always gold-bullish. The second is that when financial markets are free from manipulation they always move in concert with the fundamentals. If you hold these two totally-wrong beliefs then every time there is a significant decline in the gold price you will naturally conclude that manipulation was the cause.

The reality is that gold’s true fundamentals have been deteriorating since July and that the pace of deterioration picked up over the past three weeks. At the same time, speculators in gold futures were adding to the risk of a steep downward price adjustment by stubbornly maintaining an extremely high net-long position.

The following chart compares the gold price with the bond/dollar ratio. The fundamental deterioration and the delayed response of the gold market can clearly be seen on this chart.

Gold market participants and observers who were looking at the right indicators will not have been surprised by last week’s price decline.

*China is apparently the bastion of honest price discovery in the gold market and corrupt Western bankers apparently wait for the Chinese to go on vacation before launching their bear raids.

Anyone with rudimentary knowledge of good economic theory can explain why government price controls are a bad idea. It boils down to the fact that the optimum price is the price that naturally balances supply and demand, and to the related fact that forcing the price to be above or below the level at which supply and demand would naturally be in balance will lead to either a glut or a shortage. However, even though most people are capable of understanding why price controls are counter-productive, they still want them.

To be clear, most people living in semi-free countries are undoubtedly against the general concept of price controls, but they will be in favour of specific price controls. In a remarkable display of cognitive dissonance, they will simultaneously understand why price controls must cause economic problems and advocate for price controls in certain situations.

They will be in favour of certain price controls due to political leanings or due to being direct beneficiaries of the controls. Here are some examples:

1) Anyone who understands how supply and demand inter-relate should understand that minimum wage laws are not only counter-productive on an economy-wide basis but also cause the most problems for the group of workers they have supposedly been put in place to protect. In particular, it is axiomatic that if government intervention forces the price of labour to be higher than it would otherwise be then the demand for labour will be lower, that is, more people will be unemployed, with the additional unemployment occurring mostly within the ranks of the lowest-skilled workers. For example, if the official minimum wage is $15/hour and someone, due to their lack of experience or skills, is only worth $12/hour, then that person will be out of work. He might be eager to work for $12/hour to gain the experience/training he needs to increase the value of his labour, but the government says: “No; you will either get paid $15/hour or you will be unemployed”.

There are countless people who understand all this and yet strongly support minimum wage laws, either because the laws mesh with their political beliefs or because they personally benefit from the laws.

2) Anyone who understands basic economics should be capable of figuring out that it makes no sense for one of the most important prices in the economy to be set by a banking committee or government agency, and yet most people involved in economics and finance believe that there should be a central bank.

3) It is obvious that “rent control” legislation will lead to a shortage of rental properties and lower average standards of maintenance for existing rental properties, but the current/direct beneficiaries of the legislation (the people who live in rent-controlled housing) will often be in favour of this form of price control.

4) Price caps on utility charges will generally seem like a good idea to the people who currently benefit due to having lower electricity or water bills. That will typically be so even if these people have given the matter enough thought to understand that the artificially-low current prices will lead to less investment in future supply and less maintenance on current plant, leading, in turn, to much higher prices and/or a lower level of service in the future.

5) So-called “anti-price-gouging” laws are invariably popular during disasters, but laws that prevent prices from fully responding to a sudden shortage also reduce the incentive to speedily address the shortage. They therefore prolong the supply problem.

6) Here’s an example that I wasn’t aware of until a couple of weeks ago when I read the article posted HERE. The article discusses a dispute between companies that drill for natural gas in the US and landowners who receive royalty payments in exchange for letting the companies drill on their land. The dispute is about whether the drilling companies are entitled to deduct certain expenses from the royalty payments, but what really caught my attention was the reference to a Pennsylvania state law mandating that a landowner must receive a royalty of at least 12.5 percent of the value of the gas produced on his property.

This law was undoubtedly put in place for the benefit of landowners and most landowners are probably in favour of it, but what it means is that if the price of natural gas isn’t high enough to enable the drilling companies to afford a 12.5% royalty then production will stop and the landowners will get nothing. There’s no scope for the royalty payments to be influenced by natural market forces, although it’s possible that the drilling companies are using deductions to get around the law and reduce the effective royalty rate to a level that is economic at the current gas price.

In summary, very few people are consistently opposed to government price controls. Even people who have enough economics knowledge to understand why price controls never work as advertised find reasons to believe in particular price controls. As a consequence, most of the price controls that are now in place have a lot of supporters among the voting public and are therefore likely to remain in place.

Some analysts who are usually astute and show a good understanding of economics seem to put on blinders before looking at China. It’s as if, when considering China’s prospects, they forget everything they know about economics and refuse to see beyond the superficial. A recent example is Doug Casey’s article titled “Chung Kuo“.

Here’s an excerpt from the Casey article:

“I can give you a dozen credible scenarios describing what might happen in China over the next couple of decades. But the trend that seems certain to continue is the rapid rate of wealth increase there. I don’t credit official figures with any great accuracy, but if we take them as being approximately right, then the U.S. economy is growing at 2%, and China’s at about 7% — but with a base of about four times the population. What this means is that the largest economy on the planet will soon no longer be America’s — but China’s.”

There are two big problems with the above paragraph. First, after saying that he doesn’t credit official figures with any great accuracy he takes these figures as being approximately right. The reality, however, is that China’s reported growth figures are completed fabricated. It’s not that China’s government reports growth of 7.0% when the actual rate of growth is 6.5%; it’s that China’s government reports growth in the 6.5%-7.5% range every year regardless of what’s happening. If the economy were shrinking rapidly the government would still report growth in the 6.5%-7.5% range. Based on other measures of economic activity there have almost certainly been 12-month periods over the past 10 years when China’s economy shrank in real terms, but during these periods China’s government still reported growth of around 7%.

The second problem is that the monetary size of an economy is irrelevant to the people living in it. What matters is per-capita wealth, not aggregate wealth and certainly not aggregate spending (which is what GDP attempts to measure). For example, it’s quite possible that in size terms Nigeria’s economy will overtake Switzerland’s economy within the next few years, but so what? Nobody in their right mind is saying that if this happens then the average Swiss will be worse off than the average Nigerian, because it obviously must be taken into account that there are 175M people in Nigeria and only 8M in Switzerland.

The Casey article then goes on to list some of the things that China has going for it, but most of these things were just as applicable 100 years ago as they are today. Therefore, they aren’t critical ingredients for strong, broad-based economic progress.

Surprisingly, given that Doug Casey’s big-picture analysis is usually on the mark, the Casey article fails to address any of the most important issues. There’s no mention, for example, that China has a command economy with only token gestures towards free markets.

The true colours of China’s economic commanders were shown in 2015 following the bursting of the stock market bubble that they had purposefully created. I’m referring to how they became increasingly draconian in their efforts to stop the price decline. When words of support didn’t work, they made short-selling illegal and began to aggressively buy stocks. When that didn’t work, they forbade corporations and investment funds from selling at all and made it clear that bearish public comments about the stock market would not be tolerated. And when the market still didn’t cooperate, they started apprehending or ‘disappearing’ people suspected of placing bearish bets.

Related to the “command economy” issue is the fact that China has always had an emperor. This means that there is no history of freedom or a culture of individual-rights to fall back on. Furthermore, Xi Jinping, the current emperor (who doesn’t call himself an emperor), has shown admiration for Mao Tse Tung, the most brutal emperor (who also didn’t call himself an emperor) in China’s history.

There’s also no mention in the Casey article that over the past 10 years China has experienced the greatest mal-investment in centuries. You would have to go back to the pyramids of ancient Egypt or the building of the Terracotta Army by China’s first emperor more than 2000 years ago to find comparable examples of resource wastage on such a grand scale.

All the ghost cities, spectacular-but-mostly-vacant shopping malls, barely-used airports and bridges to nowhere have boosted the Keynesian measures of growth — such as GDP — that don’t distinguish between productive and unproductive spending. Consequently, even if the GDP growth figures reported by China’s government bore some resemblance to reality (they don’t), the reported growth wouldn’t be a reason to be optimistic because so much of it is associated with wasteful spending. Moreover, the bulk of the spending is debt-funded by State-controlled banks that would make Deutsche Bank look financially ‘rock solid’ if given a proper accounting treatment.

Next, there’s the legacy of the “one-child policy” to consider. Thanks to decades of the national birth rate being restricted by the giant boot of government, China is now facing a major demographic problem. Specifically, for at least the next couple of decades the number of prime-age workers is going to shrink relative to the elderly.

Finally, it is worth mentioning China’s mind-boggling wealth disparity. A few hundred million people are doing OK and a few million have become extremely wealthy while at least a billion people are living in abject poverty.

As to why some people who produce well-reasoned analysis of what’s happening in the Western world seem incapable of applying the same principles and logic when analysing China, I can only guess. My guess is that they are too focused on trying to show the US in a negative light to see what’s going on in China. It is, however, possible to be concerned about the direction in which the US is heading without being bullish on China.