Blog 2 Columns

At this time last year there was a lot of talk in the financial press about the huge US$ short position that was associated with the dollar-denominated debts racked up over many years in emerging-market countries. This debt-related short position supposedly guaranteed additional large gains for the Dollar Index over the ensuing 12 months. But now, with the Dollar Index having drifted sideways for 12 months and having had a downward bias for the past 5 months it is difficult to find any mention of the problematic US$ short position. Did the problem magically disappear? Did the problem never exist in the first place?

Fans of the US$ short position argument needn’t fret, because the argument will certainly make a comeback if the Dollar Index eventually breaks above the top of its drawn-out horizontal trading range. It will make a comeback regardless of whether or not it is valid, because it will have a ring of plausibility as long as the Dollar Index is rising.

I’m not saying that the argument for a stronger US$ driven by the foreign-debt-related US$ short position is invalid. I’m not saying it yet, anyway. The point I’m trying to make above is that if the argument was correct a year ago then it is just as correct today (since debt levels haven’t fallen) and should therefore be just as popular today. It is nowhere near as popular, though, because most fundamentals-based analysis is concocted to match the price action.

I actually view the “global US$ short position” as more of an effect than a cause of exchange-rate trends. Major currency-market trends are caused by differences in stock-market performance, real interest rates and monetary inflation rates. When these factors conspire to create a downward trend in the US dollar’s foreign exchange value it becomes increasingly attractive for people outside the US to borrow dollars. And when these factors subsequently conspire to create an upward trend in the US dollar’s foreign exchange value, debt repayment becomes more costly for anyone with US$-denominated debt outside the US.

So, if the Dollar Index resumes its upward trend later this year then anyone outside the US with hefty US$-denominated debt will have a problem, but the deteriorating collective financial position of these foreign US$ borrowers won’t be the cause of the dollar’s strength. It will just be a popular justification for the strength.

In general, fundamentals-based analysis will look correct and achieve popularity if it matches the price action, even if it is complete nonsense. A related point is that if fundamentals-based analysis is contrary to the recent price action then hardly anyone will believe it, irrespective of the supporting facts and logic.

It was reported last week that Deutsche Bank has settled lawsuits over allegations it manipulated gold and silver prices via the “London Fix“. This is not really news, in that experienced traders would already be aware that banks and other large-scale operators regularly attempt to shift prices one way or the other in most financial markets to benefit their own bottom-lines. I just wanted to point out that this “news” does not, in any way, shape or form, constitute evidence that there has been a successful long-term price suppression scheme in the gold and silver markets.

As far as I can tell, the banks that were involved in setting the twice-daily levels for the London gold and silver fixes had two ways of using or manipulating the ‘fix’ to generate profits. The first is that the participants in the fixing process were privy, for two very brief periods (10-15 minutes, on average) each day, to non-public supply-demand information, making it possible for them to obtain a very brief advantage in their own trading. For example, if the volume of gold being bid for was significantly greater than the volume being offered near the start of a particular day’s fixing process, a participant would know that the price was likely to rise over the ensuing few minutes and could enter a long position with the aim of exiting at around the time the ‘fix’ was announced.

The other way of using or manipulating the ‘fix’ to generate profits is more sinister, as it essentially involves the ‘fix’ participants stealing from their clients. I’m referring to the fact that although the ‘fix’ is primarily a market price, in that it is designed to reflect the bids and offers in the market at a point in time, the participating banks would have the ability to nudge the price in one direction or the other. Situations could arise where a participating bank could improve its bottom line at the expense of a client by influencing the ‘fix’ in a way that, for example, prevented an option held by the client from expiring in the money or allowing the bank to purchase gold from the client at a marginally lower price.

I don’t know that the participants in the London ‘fixing’ process sometimes used the process to increase their own profits at their clients’ expense, but I wouldn’t be the least bit surprised if they did. There was certainly a huge conflict of interest inherent in the way the ‘fix’ was conducted.

Anyhow, it’s important to understand that price distortions resulting from the ‘fix’ would have existed only briefly (for less the 20 minutes in all likelihood) and could not have affected the price trends of interest to anyone other than intra-day traders. In particular, there is simply no way that a multi-month price trend could have been shifted from bullish to bearish or bearish to bullish by manipulating the London gold or silver fix.

Last November I entered the crash-forecasting business. As explained in a blog post at the time, my justification for doing so was the massively asymmetric reward-risk associated with such an endeavour. Whereas failed crash predictions are quickly forgotten, you only have to be right (that is, get lucky) once and you will be set for life. From then on you will be able to promote yourself as the market analyst who predicted the great crash of XXXX (insert year) and you will accumulate a large herd of followers who eagerly buy your advice in anticipation of your next highly-profitable forecast. Furthermore, since a crash will eventually happen, as long as you keep predicting it you will eventually be right.

My inaugural forecast was for the US stock market to crash during September-October of 2016. The forecast was made with tongue firmly planted in cheek, since I have no idea when the stock market will experience its next crash. What I do know is that it will eventually crash. My goal is simply to make sure that when it does, there will be a written record of me having predicted it.

That being said, when I published my crash forecast last November I gave a few reasons why it wasn’t a completely random guess. One was that stock-market crashes have a habit of occurring in September-October. Another was that the two most likely times for the US stock market to crash are during the two months following a bull market peak and roughly a year into a new bear market, with the 1929 and 1987 crashes being examples of the former and the 1974, 2001 and 2008 crashes being examples of the latter. The current situation is that either a bear market began in mid-2015, in which case the next opportunity for a crash will arrive during the second half of this year, or the bull market is intact, in which case a major peak will possibly occur during the second half of this year. A third was that market valuation was high enough to support an unusually-large price decline.

A fourth reason, which I didn’t mention last November, is that if the bull market didn’t end last year then it is now very long-in-the-tooth and probably nearing the end of its life. A fifth reason, which I also didn’t mention last year because it wasn’t apparent at the time, is that the monetary backdrop has become slightly less supportive.

So, I hereby repeat my prediction that the US stock market will crash in September-October of this year, but if not this year then next year or the year after. My prediction will eventually be right, at which point I’ll bathe in the glow of my own prescience and start raking in the cash from book sales.

When the oil price was bottoming at around $26/barrel in February, most fundamentals-oriented oil-market analysts were anticipating additional weakness due to the likelihood of a continuing supply glut. In most cases they have remained bearish throughout the price recovery from the mid-$20s to the low-$40s due to the same supply-glut belief. Regardless of whether or not a sustainable oil price bottom was put in place in February*, this line of reasoning was/is wrong.

The line of reasoning was/is wrong because in the commodity markets the fundamentals always appear to be lousy at major price bottoms. In fact, as far as I can tell there has never been a major price low in the commodity markets when there did not appear to be excessive supply relative to demand for as far as the eye could see. Similarly, there has never been a major price high in the commodity markets when there did not appear to be either abundant price-boosting demand or inadequate supply for as far as the eye could see. The markets work this way because at some point during a bearish trend or a bullish trend the supply-demand story underpinning the trend becomes so well known that it is more than fully discounted by the current price.

Was the oil market’s bearish supply-demand situation more than fully discounted by the current price when oil was trading in the mid-$20s in February? Quite likely, because a) in real terms oil was near its lowest price of the past 40 years and b) at that point there was hardly anyone who didn’t know about the oil glut and who wasn’t well-versed in the argument that the glut would persist for years to come.

*I think that the oil price bottomed in February and thought so at the time, as evidenced by comments in TSI reports in mid-February and at the blog a little later. The price action hasn’t yet definitively signaled a reversal, but it’s possible that an intermediate-term reversal signal will be generated at the end of this week.

Contrary to the opinions of some hard-money advocates, money should not be backed by gold. In fact, money should not be backed by anything.

Money is the most commonly used means of final payment in an economy. Consequently, something cannot be money (a means of FINAL payment) and at the same time be backed by something else, because in that case it’s the thing that does the backing that is actually money. For example, during the period in which the US was on a Gold Standard the US dollars in circulation were not money; they were receipts for money (gold). To put it another way, during the Gold Standard period the US dollars in circulation were not money backed by gold. Rather, gold was money.

Criticism of today’s money on the basis that it is not backed by anything therefore contains a fundamental misunderstanding of money. Money (the general medium of exchange) can be almost anything, but if something is money then it cannot, by definition, be ‘backed’ by something else.

On a related matter, the Gold Standard is not a good idea. This is because it necessarily involves the government fixing a price (the price of an ounce of gold or the price of a currency unit). When the government has the power to manage/control something in accordance with certain rules, the government will always be able to change the rules to suit itself. A successful attempt to return to a Gold Standard would therefore inevitably be followed by rule changes that led back to where we are today.

What would be a good idea is to get the government completely out of the money business.

This post is a slightly-modified excerpt from a recent TSI commentary.

The COT (Commitments of Traders) data for gold is portrayed by some commentators as an us-versus-them battle, with “them” (the bad guys) being the Commercials. Whether this is done out of ignorance or because it makes a good story that attracts readers/subscribers, it paints an inaccurate picture.

As I’ve explained in numerous TSI commentaries over the years, the Commercial position is effectively just the mathematical offset of the Speculative position. Speculators, as a group, cannot go net-long by X contracts unless Commercials, as a group, go net-short by X contracts. Furthermore, we can be sure that Speculators are the drivers of the process because most of the time the Speculative net-long position moves in the same direction as the price.

With Speculators becoming increasingly long as the price rises, it will always be the case that the Speculative net-long position will be near a short-term maximum when the price is near a short-term high. This means that the Commercial net-short position must always be near a short-term maximum when the price is near a short-term high, creating the false impression that the Commercials are always right at price tops.

The reality is that the Commercials are neither right nor wrong, since they generally don’t bet on price direction. In some cases they are selling-short the futures to hedge long positions in the physical, but in the gold market the dominant Commercials are the bullion banks that trade spreads between the physical and futures. If trading and other costs are low enough and volumes are high enough, the bullion banks can guarantee themselves profits — regardless of subsequent price direction — by buying/selling gold for future delivery and simultaneously selling/buying the physical metal.

Consider, for example, the situation where Speculators increase their collective demand for gold futures. If this additional Speculative demand causes the futures price to rise relative to the spot price it can create an opportunity for a bullion-bank Commercial to simultaneously sell the futures and buy the physical, thus locking-in a profit equal to the spread (between the futures price and the spot price) less the costs of storage, insurance and financing. At a time when the official interest rate is near zero, even a tiny futures-physical spread in the gold market can create the opportunity for a profitable trade.

I’m going back over this old ground to make sure that TSI readers aren’t taken-in by the popular, but wrongheaded, conspiracy-centric us-versus-them characterisation of the COT information.

A post at ZeroHedge (ZH) on 8th April discusses an 11th April Fed meeting as if it were an important and unusual event. According to the ZH post:

“With everyone’s focus sharply attuned on anything to do with the Fed’s rate hike policy, many will probably wonder why yesterday the Fed announced that this coming Monday, April 11, the Fed will hold a closed meeting “under expedited procedures” during which the Board of Governors will review and determine advance and discount rates charged by the Fed banks.

As a reminder, the last time the Fed held such a meeting was on November 21, less than a month before it launched its first rate hike in years.”

As explained at the TSI Blog last November in response to a similar ZH post, these “expedited, closed” Fed meetings happen with monotonous regularity. For example, there were 5 in March, 4 in February and 5 in January. Furthermore, ZH’s statement that 21 November was the last time the Fed held such a meeting to “review and determine advance and discount rates charged by the Fed banks” is an outright falsehood. The fact is that a meeting for this purpose happens at least once per month. For example, there were 2 such meetings in March and 1 in February.

Is it possible that the misinformation in the above-linked ZH post was an honest mistake? Yes, it’s possible, but it isn’t likely.

The most important fundamental driver of the gold market that hasn’t yet begun to move in a gold-bullish direction is the US yield curve, represented on the following chart by the 10yr-2yr yield spread. The yield curve is bullish for gold when it is getting steeper, as indicated by a rising 10yr-2yr yield spread (a rising line on the following chart). With the 10yr-2yr yield spread having recently made a new 8-year low and not yet shown any sign of reversing upward, the yield curve remains unequivocally gold-bearish.

The yield curve is also one of the most important economic indicators to not yet warn of a US recession. Note that contrary to popular opinion it isn’t an inversion of the yield curve (the 10yr-2yr yield spread dropping below zero) that warns of a recession, it’s a trend reversal from flattening to steepening after the yield-spread has fallen to a multi-year low.

Based on what happened over the past 50 years, a trend reversal in the yield spread is not a prerequisite for a gold bull market. As long as sufficient other fundamental drivers (e.g. credit spreads and the real interest rate) are gold-bullish it is possible for gold to commence a bull market in the absence of a supportive yield curve. This is exemplified by the bull market that began during 1976-1977. However, it would be unprecedented for a US recession to begin in the absence of an upward reversal in the 10-yr-2yr yield spread.