According to my Gold True Fundamentals Model (GTFM), the gold market’s “true fundamentals” most recently shifted from bearish to bullish in December of last year. As indicated on the following weekly chart by the blue line being above 50, at the end of last week they were still bullish. This means that the fundamental backdrop is still applying upward pressure to the gold price.

As previously explained, I use the term “true fundamentals” to distinguish the fundamentals that actually matter from the largely irrelevant issues that many gold-market analysts and commentators focus on.

According to many pontificators on the gold market, gold’s fundamentals include the volume of metal flowing into the inventories of gold ETFs, China’s gold imports, the amount of “registered” gold at the Comex, India’s monsoon and wedding seasons, jewellery demand, the amount of gold being bought/sold by various central banks, changes in mine production and scrap supply, and wild guesses regarding JP Morgan’s exposure to gold. These things are distractions at best. For example, a gold investor/trader could have ignored everything that has been written over the past 20 years about the amount of gold in Comex warehouses and been none the worse for it.

On an intermediate-term (3-12 month) basis, there is a strong tendency for the US$ gold price to trend in the opposite direction to confidence in the US financial system and economy. That’s why most of the seven inputs to my GTFM are measures of confidence. Two examples are credit spreads and the relative strength of the banking sector. The model is useful, in that over the past two decades all intermediate-term upward trends in the gold price occurred while the GTFM was bullish most of the time and all intermediate-term downward trends in the gold price occurred while the GTFM was bearish most of the time.

However, upward corrections can occur in the face of bearish fundamentals and downward corrections can occur in the face of bullish fundamentals. For example, there was a sizable downward correction in the gold market in March of this year in the face of bullish fundamentals. Such corrections often are signalled by sentiment indicators.

Right now, the fundamentals are supportive while sentiment is warning of short-term downside risk.

As long as the fundamentals remains supportive, any short-term decline in the gold price should be ‘corrective’, that is, it should be within the context of a multi-year upward trend.

In a blog post on 31st March I argued that MMT (Modern Monetary Theory) had been surreptitiously put into practice in the US. However, according to a quote from Lacy Hunt (Hoisington Investment Management) included by John Mauldin in a recent letter, what the Fed and the US government are doing doesn’t qualify as MMT.

According to Lacy Hunt: “For the Fed to engage in true MMT, a major regulatory change to the Federal Reserve Acts would be necessary: The Fed’s liabilities would need to be made legal tender. Having the Treasury sell securities directly to the Fed could do this; the Treasury’s deposits would be credited and then the Treasury would write checks against these deposits. In this case, the Fed would, in essence, write checks to pay the obligations of the Treasury. If this change is enacted, rising inflation would ensue and the entire international monetary system would be severely destabilized and the US banking system would be irrelevant.”

One problem with Lacy Hunt’s argument is that some of the Fed’s liabilities are already legal tender and have been for a very long time. I’m referring to the $1.9 trillion of “Currency in circulation” (physical notes and coins). This currency sits on the liability side of the Fed’s balance sheet. Also, the money that the US Treasury spends comes from the Treasury General Account, which also sits on the liability side of the Fed’s balance sheet.

Admittedly, the Fed currently does not buy Treasury debt directly. Instead, it acts through Primary Dealers (PDs). The PDs buy the debt from the government and the Fed buys the debt from the PDs. When this happens, new money is credited by the Fed to the commercial bank accounts of PDs and thus becomes a liability of the private banking system. At the same time, the private banks are ‘made whole’ by having new reserves added to their accounts at the Fed.

In other words, rather than money going directly from the Fed to the Treasury General Account (TGA), under the current way of doing things the money gets to the same place indirectly via PDs. This enables the commercial banking system to get its cut, but from both the government’s perspective and the money supply perspective there is no difference between the Fed directly buying government debt and the Fed using intermediaries (PDs) to do the buying.

Now, the Fed’s QE programs of 2008-2014 generated a lot less “price inflation” than many people feared. This was largely because the new money was injected into the financial markets (bonds and stocks) and only gradually trickled into the ‘real economy’. To some extent what happened over the past couple of months is similar, but with two significant differences.

One significant difference between the Fed’s recent actions and the QE of 2008-2014 is that for some of its new money and credit creation the Fed is bypassing the PDs. No regulatory change was needed for this to happen. Instead, as I explained in my earlier post, the Fed created Special Purpose Vehicles (SPVs) that do the actual monetising of assets and the lending of new money into existence. In effect, new money is now being created by the Fed and sent directly to various non-bank entities, including municipalities, private businesses and bondholders.

The second significant difference is the crux of the issue and why the US now has MMT in all but name.

You see, the essence of MMT isn’t the mechanical process via which money gets to the government. The essence is the concept that the government is only limited in its money and debt creation by “inflation”. The idea is that until “inflation” becomes a problem, the government can create as much new money and debt as it wants as part of an effort to achieve full employment. A related idea is that government spending does not have to be financed by taxation.

Is there really any doubt that the US government no longer feels constrained in its creation of debt, the bulk of which is being purchased indirectly using new money created by the Fed? After all, in the space of less than two months the US federal government has blown-out its expected annual deficit from around $1T to around $4T and is talking about massive additional spending/borrowing increases to support the economy. Clearly, no senior politician from either of the main parties is giving any serious thought to how this debt will be repaid or the future implications of the deficit blow-out.

The bottom line is that the US doesn’t have MMT in law, but it does have MMT in fact.

Economics isn’t about money. Money is important because it facilitates the division of labour, but good economic theory applies with or without money. Economics is about how humans allocate scarce resources. This implies that trade-offs are critical to the good economist, because he/she understands that allocating scarce resources to satisfy one need in the present means that these resources will not be available to satisfy another need in the present or the future*. Right now, the entire world is dealing with a trade-off that has far-reaching consequences.

The trade-off is associated with the COVID-19 threat and has been portrayed as being between lives and money, but the correct way to view the trade-off is between lives today and lives in the future. Unfortunately, the people making the decisions regarding what should be done have neither the data nor the knowledge to properly analyse the trade-off.

For one thing, when decisions were made to implement widespread lock-downs these people clearly had no inkling of the short-term cost, in terms of illness and lives, of NOT locking down the economy. We know this because as recently as six weeks ago there were projections of millions of deaths in the US alone**, but the actual rates of death and serious illness have been vastly lower than projected. The experts who made these wildly inaccurate forecasts claim that the vastly lower death rates are due mainly to the lock-downs, but we know this isn’t true based on what happened in countries that didn’t implement draconian social distancing measures. For example, although Sweden, which was not forced into lock-down mode, has experienced a slightly higher rate of infection than its Scandinavian neighbours, its rate of COVID-19 infection is about the same as that of Germany, which is considered to have done a good job of containing the virus via strict social-distancing measures, and much lower than those of Spain, Italy, France and the US.

Even more importantly, the decision-makers are clueless about the long-term costs, in terms of lost lives and lowered living standards, that likely will result from the lock-downs. How could they not be clueless, because in order to make a reasonable assessment you must have a thorough understanding of history and good economic theory. As far as I can tell, not one of the health/medical officials or political leaders at the forefront of the COVID-19 decision-making process has this understanding.

Regarding the cost to human life stemming from locking down large sections of the economy, there is a lot of evidence that people who are poor and out of work are more likely to die than people who are financially comfortable. This is not only because the poorer people have access to lower-quality healthcare and food, but also because they are more prone to stress-related diseases and/or more likely to be subject to physical violence. In addition, a more immediate negative consequence of the lock-downs is that some people have been denied elective surgeries and others have decided not to seek immediate medical treatment for minor issues. This will lead to many deaths over the coming 12 months that would have been avoided with earlier medical intervention.

Note that I refer to GOOD economic theory above, because only a good economist is capable of comprehending the indirect, long-term and unintended consequences of a policy. A bad economist may well believe that shutting down the entire economy for 2+ months is akin to a very long weekend, and that everything will go back to normal soon after the shut-down ends — just like it does every Monday following the 2-day weekend shut-down. Larry Summers is a case in point.

The upshot is that people with power/authority are making decisions regarding a major trade-off between lives today and lives in the future while being in possession of insufficient information about one side and almost no information/knowledge about the other side of the trade-off.

*This is related to Frederic Bastiat’s Broken Window parable, in that what is immediately obvious is the benefit achieved by allocating the resource to satisfy one current need but what isn’t immediately obvious are the benefits that would have accrued if the resources had been allocated differently.

**The experts at Imperial College predicted 2.2M deaths in the US and 510K deaths in the UK.

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

Last week, a highly paid (we assume) JP Morgan analyst opined:

“When it comes to market developments, we believe that the Fed’s action last Thursday represents a pivotal moment in this crisis. Powell’s statement included that “we will continue to use these powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery” and probably the most important, historic statement, “We should make them whole. They did not cause this.” This crisis is different from any other in recent history in that it was not caused in any way by businesses or investors. Unhindered by moral hazard, the response of fiscal and monetary authorities is and will continue to be unprecedented, with the goal of essentially making everyone ‘whole.’ We believe the significance of this development is underestimated by markets, and this reinforces our view of a full asset price recovery, and equity markets reaching all-time highs next year, likely by H1. Investors with focus on negative upcoming earnings and economic developments are effectively ‘fighting the Fed,’ which was historically a losing proposition.”

Well, if moral hazard was the only thing that prevented the Fed from acting in the past to eliminate everyone’s losses, then why has the Fed never bothered to eliminate poverty? After all, not every poor person is in that situation due to having done something wrong. In particular, none of the children living in poverty are to blame for their predicament.

Taking a broader view, if it is possible for the central bank to make everyone “whole”, then why are some countries poor? These countries have central banks that are capable of doing what the Fed is now promising to do.

The problem, of course, is that the central bank cannot add real wealth to the economy. It cannot produce anything of real value. All it can do is conjure money and credit out of nothing, thus setting in motion countless exchanges of nothing for something and distorting the price signals upon which markets rely. This is a recipe for more poverty and generally lower living standards in the long term.

At some point during the second half of this year, the release of pent-up demand as restrictions are removed and people go back to work, combined with the flood of new money generated by the Fed, could make it seem as if there has been a ‘V’ bottom in the economy and that the entire recession lasted only about four months. This could enable the SPX to return to within 10% of its February-2020 all-time high before year-end. However, the price distortions that have been and will be caused by the effort to make everyone “whole” will prevent a sustainable recovery.

The deluge of new money will boost asset prices and the prices of life’s necessities, but many businesses that closed their doors during March of 2020 will never re-open and many people who lost their jobs will remain unemployed (and thus dependent upon government handouts). Also, many of the people who do end up with jobs will find that their real incomes have fallen, because there will be an excess supply of labour and the currency’s loss of purchasing power will be reflected to the greatest extent in the prices of things that are in relatively short supply. For the majority of people, therefore, the post-shutdown economy will never be as good as the pre-shutdown economy, not despite the Fed’s efforts but largely because of them.