The gold sector: close, but no cigar…yet

May 15, 2015

Gold bullion and the Gold BUGS Index (HUI) are close to breaking out to the upside on the daily charts. As shown below, the US$ gold price is butting up against lateral resistance that also now coincides with the 200-day moving average (MA), and the HUI is struggling with resistance defined by a trend-line that dates back to the August-2014 short-term top. Are they going to break out and what will it mean if they do?

gold_140515

HUI_140515

While I expect that gold bullion and the HUI will rise to much higher levels during the second half of this year, I don’t have a strong opinion on whether they will break above their nearby resistance levels within the next few weeks. If I had to make a guess I’d say that they will break out within the next few trading days, but this is not something I’m betting on. In any case, if breaks above these resistance levels occur in the near future it won’t mean much. In particular, multi-week tops could follow closely on the heels of upside breakouts.

The reason that breaks above the aforementioned resistance levels won’t mean much is that the resistance levels, themselves, aren’t important. For one, gold’s resistance at $1220 is primarily defined by a few minor spike-highs over only the past two months (the 200-day MA is not usually a significant resistance level for gold). For another, angled lines drawn on charts, such as the lines drawn on the HUI chart displayed above, are always subjective interpretations and somewhat arbitrary.

By the way, GDX and the XAU have already broken above similar lines to the line drawn on the above HUI chart. Here’s an XAU chart showing the breakout. In the grand scheme of things, this breakout doesn’t matter.

XAU_140515

The point I want to make is although breaks above the price-related obstacles that are currently being challenged won’t give us useful new information, it won’t take much additional strength from here to effect upside breakouts that really do mean something. For example, in terms of confirming a major turn to the upside the HUI resistance that matters is in the low-200s, or only about 10% above Thursday’s high.

Print This Post Print This Post

ASS Economics

May 12, 2015

To the Keynesian economist, the world of economics is a sequence of random events — an endless stream of anecdotes. Things don’t happen for any rhyme or reason, they just happen. And when they happen the economist’s first job is to come up with an explanation by looking at the news of the day, because there will always be current events that can be blamed for any positive or negative developments.

It’s futile to look any deeper, for example, to consider how policies such as meddling with interest rates might have influenced investment decisions, because, even though the real-world economy involves millions of individuals making decisions for a myriad of reasons, the individual actors within the economy supposedly form an amorphous mass that shifts about for unfathomable reasons. In fact, in the Keynesian world the economy can be likened to a giant bathtub that periodically fills up and empties out for reasons that can’t possibly be understood, although if an explanation that goes beyond the news of the day is needed the economist can always fall back on “aggregate demand” or its more emotional cousin — “animal spirits”. Specifically, a slowing economy can be said to be the result of falling “aggregate demand”, and when the pace of economic activity is rapid it can be said to be the result of surging “animal spirits”. There’s no need to try to explain the changes in these mysterious entities, because they are inexplicable. They just happen.

Having explained what’s happening to the economy by pointing at seemingly random/unpredictable events or citing unfathomable changes in “aggregate demand”, the economist’s second job is to recommend a course of action. And since the economy can supposedly be likened to a bathtub filled with an amorphous liquid, the level of which periodically rises and falls, it’s up to the economist to suggest ways that add liquid when the level is too low and drain liquid when the level is too high.

Fortunately, adding and draining liquid is very easy to do. For example, to add liquid all that has to be done is for the government to increase its spending and/or for the central bank to create some money out of nothing. It doesn’t matter that the government’s spending is unproductive and that the central bank’s money-pumping falsifies the price signals upon which the market relies; it only matters that more liquid is added to the bathtub.

This approach to economics might seem ad-hoc. It might seem superficial. And it might seem short-sighted. That’s because it is all of these things, which is why Keynesian Economics should be re-branded ASS (Ad-hoc, Superficial and Shortsighted) Economics.

Print This Post Print This Post

The futures price is not a price prediction

May 11, 2015

The price of a commodity futures contract is not the market’s forecast of what the spot price will be in the future. For example, the fact that at the time of writing the price of the December-2016 WTI Crude Oil futures contract is $64.44 does not imply that ‘the market’ expects the price of oil to rise from around $59 (the current spot price) to around $64 by the end of next year. Moreover, the true message of the difference between the futures price and the spot (cash) price can be the opposite of the superficial message, in that the lower the futures price relative to the spot price the more bullish the price implication. If you understand why this is so then you understand more than former Fed chief and present-day blogger Ben Bernanke about how the commodity futures markets work, which, admittedly, is not saying very much.

Part of the reason that the price of a commodity futures contract is not a prediction of the future price of the commodity is that many of the largest participants in the futures markets do not buy/sell futures contracts based on a forecast of what’s going to happen to the price. Instead, they use the futures market to hedge their exposure in the cash market. For example, when an oil producer sells oil futures it is probably doing so because it wants to lock-in a cash flow, not because it expects the price to go down.

The main reason, however, is that the difference between the futures price and the spot price is driven by arbitrage and, in all commodity markets except the gold market, the extent to which current production is able to satisfy current demand (in the gold market there can never be a supply shortage because almost all of the gold mined in world history is still available to meet current demand). In effect, regardless of what people think the price of the commodity will be in the future, arbitrage trading will prevent the futures price from deviating from the spot price after taking into account the cost of credit (the interest rate) and the cost/availability of storage.

Considering the case of the oil market, I mentioned above that the spot price is currently about $59 and the price for delivery in December-2016 is about $64. This $5 difference does not imply that ‘the market’ expects the price of oil to be $5/barrel higher in December-2016 than it is today; it implies that the cost of storing oil for the next 18 months plus the interest income that would be foregone (or the interest that would have to be paid) equates to about $5/barrel. If not, there would be a risk-free arbitrage profit to be had.

For example, if a large speculator who was very bullish on oil bid-up the price of the December-2016 oil contract from $64 to $70, it would create an opportunity for other traders to lock-in a profit by purchasing physical oil and selling the December-2016 futures with the aim of delivering the oil into the contracts late next year. This trade (selling the December-2016 futures and buying the physical) would continue until the difference between the spot and futures prices had fallen by enough to eliminate the profit potential.

For another example, if a large speculator who was very bearish on oil aggressively short-sold the December-2016 oil contract, driving its price down from $64 to $60, it would create an opportunity for other traders to lock-in a profit by selling physical oil and buying the December-2016 futures with the aim of eventually replacing what they had sold by exercising the futures contracts. Even though in this example the December-2016 futures contract is still $1 above the spot price, there is a profit to be had because the cost of storage plus the time value of money amounts to significantly more than the $1/barrel futures premium.

I also mentioned above that the true message of the difference between the futures price and the spot (cash) price can be the opposite of the superficial message, in that the lower the futures price relative to the spot price the more bullish the price implication. I’ll use the same oil example to explain why.

As I pointed out, if the futures price falls by enough relative to the spot price it will lead to a situation where there is an essentially risk-free arbitrage profit to be made by selling the physical and buying the futures. However, this trade is only possible if the physical market is well supplied. If this isn’t the case and all the oil being produced is needed for current consumption, then the price of oil for future delivery can drop to an unusually low level relative to the spot price and stay there. If the current supply situation is tight enough then the futures price could even drop below the spot price. That’s why a sustained situation involving an unusually-low futures price relative to the spot price has bullish, not bearish, price implications.

My final point is that one of the most important influences on the difference between spot and futures prices for many commodities is the prevailing interest rate. In the gold market it is the most important influence by a country mile. The lower the interest rate the smaller the difference will tend to be between the spot price and the prices for future delivery, so in a world dominated by ZIRP (Zero Interest Rate Policy) the differences between spot and futures prices will generally be smaller than usual.

In conclusion, anyone who views an unusually-large premium in the commodity futures price as bullish and an unusually-low (or negative) premium in the commodity futures price as bearish is looking at the market bass-ackwardly.

Print This Post Print This Post

Large sums of cash are hot potatoes

May 9, 2015

There’s a line of thinking to the effect that Quantitative Easing (QE) is not inflationary because it involves the exchange of one cash-like instrument for another. Taking the case of the US, the Fed’s QE supposedly adds X$ of money to the economy and simultaneously removes X$ of “cash-like” securities, leaving the total quantity of “cash-like” instruments unchanged. However, even putting aside the fact that many of the securities purchased as part the Fed’s QE programs are not remotely “cash-like” (nobody with a modicum of economics knowledge would claim that a Mortgage-Backed Security was cash-like), this line of thinking is patently wrong.

The simplest way for me to explain why it is patently wrong is via a hypothetical example that accurately reflects the situation in the real world. In my example, Jack is a securities dealer who deals directly with the Fed.

As part of a QE program the Fed wants to buy $1B of 2-year T-Notes with newly-created cash. Jack has $1B of T-Notes to sell, so a transaction occurs. If the Fed and Jack had simply swapped securities then there would be nothing inflationary about this transaction. Instead of holding the $1B of T-Notes yielding, say, 0.6%, Jack would be left with $1B of some other income-producing asset. However, what Jack is actually left with is a bank deposit containing 1 billion dollars of money earning 0%. Moreover, whereas he previously had no risk of suffering a nominal loss (assuming that he was prepared to hold the Notes to maturity), he now bears a low-probability risk of suffering a large nominal loss since only a tiny fraction of his $1B deposit is government guaranteed. Consequently, Jack will be quick to spend the money received from the Fed, most likely by purchasing some other bonds or perhaps by purchasing some equities.

Let’s assume that Jack uses half of the money received from the Fed to buy bonds from Bill and the other half to buy bonds from Ted. Bill and Ted are hedge fund managers. Following this transaction, Bill and Ted now each have the ‘problem’ of finding something to do with $500M of cash, because, like Jack, they can’t just leave such a large sum in a zero-interest bank deposit. They therefore quickly turn around and buy other assets, shifting the ‘problem’ of what to do with the cash to the sellers of those assets.

Get the picture? When the Fed injects money via its QE programs it is, in effect, passing a hot potato to securities dealers. The hot potato quickly gets handed off to other dealers and speculators, giving the demand for various financial assets an artificial boost along the way. Eventually the money will leak out of the bank accounts of large-scale speculators and begin to boost prices outside the financial markets, but, as we’ve seen, that process can take a long time.

Print This Post Print This Post