Blog 2 Columns

The gold market is generally weak relative to the industrial metals markets during the boom phase of the inflation-fueled, central-bank-sponsored boom/bust cycle and strong relative to the industrial metals markets during the bust phase of the cycle. In other words, the gold/GYX ratio (gold relative to the Industrial Metals Index) tends to fall during the booms, which are periods when economic confidence rises while mal-investment sets the stage for an economic contraction, and rise during the busts, which are periods when the mistakes of the past come to the fore. This is due to gold’s historical role as a store of purchasing power and a hedge against uncertainty.

By shading the bust periods in grey, I’ve indicated the global booms and busts on the following chart of the gold/GYX ratio. During the 16-year period covered by the chart there have been three busts: the recession of 2001-2002 that followed the bursting of the NASDAQ bubble, the global financial crisis and “great recession” of 2007-2009, and the euro-zone sovereign debt and banking crisis of 2011-2012.

The booms tend to fall apart more quickly than they build up, so the rising trends in the gold/GYX ratio tend to be shorter and steeper than the falling trends.

Gold/GYX’s current situation looks most similar to Q2-2007. At that time the ratio tested its late-2006 bottom and then reversed upward, marking the end of the boom that began in 2003. However, gold will soon have to start strengthening relative to industrial metals such as copper in order for the 2007 similarity to be maintained. If this doesn’t happen and the gold/GYX ratio breaks decisively below its December-2013 bottom, it will indicate that the boom is going to extend into 2015.

I want to stress that gold’s relationship to the boom/bust cycle is primarily about its performance relative to other commodities, especially the industrial metals. It is not about gold’s performance in US$ terms. For example, from mid-2005 through to mid-2006 gold performed poorly relative to the industrial metals, but this was a good time to be long gold and a very good time to be long gold stocks. It’s just that the industrial metals handily outperformed gold during this period, which makes sense considering the global economic and financial-market backdrop at the time. For another example, from May through November of 2008 gold performed extremely well relative to the industrial metals. This makes sense considering the global economic and financial-market backdrop of the period, but it was a bad time to be long gold and a very bad time to be long gold stocks.

Over the past 15 years there have always been very compelling reasons to short Japanese Government Bonds (JGBs), but almost everyone who has attempted to make money by shorting JGBs has ended up losing money. The consistency with which bearish JGB speculators have lost money over a great many years led to the short-selling of JGBs becoming known as the “widowmaker trade” and spawned the saying: “you can’t claim to be a speculator until you’ve lost money shorting JGBs”.

As evidenced by the steady downward trend on the following Bloomberg.com chart of the 10-year JGB yield, anyone who has attempted to short the JGB since the beginning of this year has lost money. In other words, the “widowmaker trade” is still living up to its name. Moreover, with the exception of a few days during early-April of last year, the 10-year JGB yield has never been lower than it is right now.

Actually, despite the steady upward grind in price and downward grind in yield, I doubt that many speculators have lost money shorting JGBs this year. The reason is that the market for JGBs no longer functions like a real market. It has effectively been squashed by the gigantic boot of the Bank of Japan (BOJ).

Due to the BOJ’s policy of buying-up every piece of government debt it can get its hands on, the JGB is so over-priced that there are no buyers apart from the BOJ. At the same time, nobody in their right mind would bet against a high-priced investment that was being supported by a totally committed buyer with infinitely deep pockets. Consequently, for all intents and purposes the JGB market is dead.

Given the proclivity of the US monetary authorities to copy Japan’s worst policy choices, speculators who believe that they will make a fortune over the years ahead by shorting US government bonds should probably re-think their stance. After all, if a Keynesian remedy fails dismally in Japan, it can only be because the remedy wasn’t implemented aggressively enough.

It is illogical to expect an artificially-low interest rate to help the economy. This is because the best-case scenario resulting from interest-rate suppression is a wealth transfer from savers to speculators. In other words, the best case is a ‘wash’ for the overall economy. The realistic case, however, is very much a negative for the overall economy, because in addition to punishing savers an artificially low interest rate will cause mal-investment and thus make the economy less efficient.

Furthermore, thanks to the Japanese experience of the past two decades there is now a mountain of recent empirical evidence to support the logic outlined above. Japan’s policymakers have tried and tried again to propel their economy to the mythical “escape velocity” by pushing interest rates down to absurdly low levels and keeping them there, but every attempt has failed. Unfortunately, the fact that interest-rate suppression has been a total bust in Japan has not dissuaded other central banks from going down the same path.

The root of the problem is devotion to bad economic theory. If you are convinced that lowering the interest rate, pumping money into the economy and ramping-up government spending is beneficial, then from your perspective a failure of such measures to sustainably boost the rate of economic growth can only mean that the measures weren’t aggressive enough. If the interest rate is reduced to zero and the economy remains sluggish, then a negative interest rate must be needed. If the economy doesn’t become strong in response to 10% annual money-supply growth, then 15% or 20% annual monetary expansion is obviously required. If a hefty boost in government spending fails to kick-start the economy, then it must be the case that government spending wasn’t boosted enough.

The alternative is that the theory underlying the policy is completely wrong, but this possibility must never be acknowledged.

A popular view is that the Bank of Japan (BOJ) is inflating the Yen to oblivion. This view is wrong. The reality is that while there is certainly a risk that the BOJ will eventually inflate Japan’s money supply at a fast pace, it is not currently doing so.

The spectacular QE program introduced by the BOJ in April of last year did have some effect on the money supply, but the effect was nowhere near as great as generally believed. As illustrated by the chart displayed below, the year-over-year (YOY) rate of increase in Japan’s M2 money supply rose from around 3% in early-2013 to just above 4% near year-end, but 4% is a long way from the explosive growth that most analysts thought would result from the BOJ’s new Yen-depreciation policy. Furthermore, the YOY rate of increase in Japan’s M2 has since drifted down to 3% and appears to be on its way back to the long-term average of 2% (I think it will be back at 2% by October). This means that Japan is still maintaining the world’s lowest monetary inflation rate, which prompts me to ask: Why are so many analysts still blindly assuming that the BOJ is rapidly expanding the Yen supply? Why aren’t they spending the 15 minutes that would be needed to validate — or in this case invalidate — their assumptions by checking the money-supply figures available at the BOJ web site?

An implication of the above is that the supply side of the Yen’s supply-demand equation remains bullish for the Yen’s exchange rate. However, for most currency traders this doesn’t matter. The reason is that the supply side dominates very long-term trends in the foreign exchange market, but the demand side often dominates over periods of up to 2 years.

One of the main reasons that T-Bonds continue to rise in price (fall in yield) is that most speculators continue to bet on a price decline (a rise in long-term interest rates). In other words, the sentiment backdrop remains supportive. It’s worth noting, for example, that despite the strong and consistent upward trend of the past 9 months, there is still a substantial speculative net-short position across the 30-year T-Bond and 10-year T-Note futures markets. Therefore, higher T-Bond/T-Note prices and lower long-term interest rates probably lie in store.

That being said, the iShares 20+ Year Treasury ETF (TLT) is now a) very ‘overbought’ by some measures (momentum, not sentiment), b) within 2% of intermediate-term resistance at 120, and c) within 6% of its mid-2012 all-time high. A test of resistance at 120 will almost surely happen and a test of the all-time high will possibly happen prior to the next intermediate-term peak, but a sustained break into all-time-high territory is very unlikely.

TSI was short-term bullish on US Treasury bonds from mid-December of last year through to mid-August of this year, but turned short-term “neutral” in a report published on 17th August. I expect to see additional gains in the T-Bond price and additional declines in the T-Bond yield over the next few months, but the short-term risk/reward is no longer skewed towards reward. It is also not skewed towards risk, meaning that it doesn’t yet make sense to bet against this market.

The extent to which monetary stimulus weakens an economy’s foundations and gets in the way of real progress will be proportional to the aggressiveness of the stimulus. This is because the greater the monetary stimulus, the greater the part within the overall economy that will end up being played by ‘bubble activities’ (businesses, projects, investments and speculations that only seem viable due to artificially low interest rates and a constant, fast-flowing stream of new money). That’s why the unprecedented (at that time) monetary stimulus of 2001-2005 led to the most severe economic fallout in more than 50 years, and why the even more over-the-top monetary stimulus of 2008-2013 has paved the way for an economic downturn of even greater severity than that of 2007-2009.

I’ll be writing more about the coming economic bust (aka severe recession or depression) over the next several months, especially if signs appear that it will soon get underway. For now, here are a few preliminary thoughts:

1) The next economic bust is likely to be worse than, and different from, the one that occurred during 2007-2009. What I mean is that the next bust is unlikely to be an amplified version of what happened previously. The main reason is that almost everyone, including the monetary central planners, will be prepared for a repeat of 2007-2009. Of particular relevance, whereas the Fed didn’t start to pump money into the economy until almost 12 months after the start of the 2007-2009 financial crisis and economic recession (the Fed began to cut its targeted interest rate in September of 2007, but it didn’t begin to monetise assets in a way that boosted the monetary inflation rate until September of 2008), it’s likely that the next time around the Fed will be much quicker to ramp up the money supply.

2) Due to the much quicker application of monetary ‘accommodation’ to counteract future economic weakness, the next bust could be associated with sharply rising commodity prices. This would be due to commodity hoarding in reaction to the belief that money is being trashed.

3) In the lead-up to and during the next economic bust, gold will probably be the best investment because it is the most logical commodity for large investors to hoard. It is the most logical commodity-refuge due to its global liquidity, its globally recognised value, the fact that the amount of gold used in commercial/industrial applications is trivial compared to the amount of gold held for monetary/investment/speculative purposes, and the distinct possibility that a collapse of or an existential threat to the current monetary system would result in gold returning to its traditional role as money.

4) The next economic bust won’t be caused by a geopolitical event, such as the disintegration of Ukraine and/or Iraq, but it will likely be exacerbated by restrictions placed on international trade due to increasing geopolitical tension.

5) The timing of the next bust is currently unknown. Two years ago I thought that it would be well underway by now, but it’s clear that negative real interest rates have a remarkable ability to postpone the day of reckoning. My current guess is that it will begin in 2015.

6) Three things I expect to see shortly before the start of the next economic bust are: a) the S&P500 Index dropping well below its 200-day moving average; b) evidence across the financial markets of a general increase in risk aversion (e.g. widening credit spreads, strength in gold relative to most other commodities); and c) a decline in the US monetary inflation rate to below 7%.

Here’s something I wrote at TSI last April:

“In a market environment where debt and equity financing is often either expensive or difficult for a junior gold (or silver) miner to obtain, a streaming deal can look attractive. This is a deal whereby a miner sells the right to purchase part of its future production at a very low price (usually no more than $400/oz for gold) in exchange for an upfront payment, with the upfront payment generally being used to finance the development or expansion of a mine. The company buying the future production “stream” will typically be Franco Nevada (FNV), Royal Gold (RGLD), Silver Wheaton (SLV) or Sandstorm Gold (SAND).

While a “streaming” deal can look like a reasonable way for a junior miner to meet its short-term financing needs at the cost of reduced future profitability, the risk is that by entering into the streaming deal the junior miner has completely relinquished its opportunity to make a profit in the future. This is because most gold mines have slim profit margins after all costs are accounted for. Due to these typically-slim margins, a miner that agrees to sell 10%-20% of its future production to a royalty or streaming company at a nominal price could end up with nothing for its own stockholders even if it doesn’t encounter major operational problems. In effect, the mine could end up being operated solely for the benefit of the royalty/streaming company.

The upshot is: beware of junior mining companies that have entered into streaming deals. Before you invest in such a company, make sure that there will be plenty of money left over for the stockholders of the junior miner after the royalty/streaming company has taken its share and ALL costs are taken into account. And bear in mind that Franco Nevada, Royal Gold and Silver Wheaton have very high valuations for a reason. The reason is that they tend to get the better of these deals.”

I was reminded of this by the “streaming” deal announced by True Gold Mining (TGM.V) last week. TGM is a stock I’m long. The stock market is less concerned than I am about the negatives of streaming deals, but I wish that TGM’s management had opted for a different method of financing the construction of the Karma gold mine.

In the gold market, the Commercials are NOT the proverbial “smart money” with respect to forecasting price direction. If they were then they wouldn’t have been net-short gold futures, to one degree or another, during the entire 2001-2011 upward trend in the gold price.

The Commercials are also not the “dumb money” with respect to forecasting price direction. This is because, as a group, they do not bet on price direction. Instead, they generally attempt to make money on spreads and commissions, regardless of price direction. Furthermore and as previously explained, the Commercial position in the futures market is simply the inverse of the Speculative position. In order for speculators, as a group, to increase their long exposure and drive the price upward, the Commercials, as a group, MUST increase their short exposure. A rise in the Commercial net-short position to a high level is therefore a function of basic mathematics — a necessary offset to a rise in the speculative net-long position to an equivalent high level. We realise that this assessment has the disadvantage of being nowhere near as interesting as the idea that Commercial traders are conspiring to keep a lid on the gold price, but it has the advantage of being factually correct.

Recently, the relatively high speculative net-long position (and the offsetting relatively high Commercial net-short position) in gold futures has been acting as a bearish hook. The problem for the short-term bears who are ‘hanging their hats’ on the COT data is that while it is correct to view a sharp rise in the speculative net-long position as a sign that the market is short-term ‘overbought’ and vulnerable to a significant pullback, there are no absolute benchmarks when it comes to the COT sentiment indicator (that’s all it is: a sentiment indicator). So, although the recent peak of 166K contracts in the total speculative net-long position in Comex gold futures is high relative to where this indicator has been over the past year, it could be low relative to where this indicator goes over the next two months. It’s possible, for example, that a rally in the gold price to the low-$1400s within the next two months will be accompanied by a rise in the total speculative net-long position to 250K contracts. Imagine how bearish the COT-focused analysts will be if that happens!