The ‘true fundamentals’ began shifting in gold’s favour in October of last year and by early-December the fundamental backdrop was gold-bullish for the first time in almost a year. However, there is not yet confirmation of a new gold bull market from the most reliable indicator of gold’s major trend. I’m referring to the fact that the gold/SPX ratio is yet to achieve a weekly close above its 200-week MA. Here’s the relevant chart:

The significance of the gold/SPX ratio is based on the concept that the measuring stick is critical when determining whether something is in a bull market. If a measuring stick is losing value at a fast pace then almost everything will appear to be in a bull market relative to it. For example, pretty much everything in the world has been rising in value rapidly over the past few years when measured in terms of the Venezuelan bolivar. It should be obvious, though, that not everything can be simultaneously in a bull market. To determine which assets/investments are in a bull market we can’t only go by performance relative to any national currency; we must also look at the performances of assets/investments relative to each other.

That’s where the gold/SPX ratio comes in. Gold and the world’s most important equity index are effectively at opposite ends of the ‘investment seesaw’. Due to their respective natures, if one is in a long-term bull market then the other must be in a long-term bear market. In multi-year periods when they are both trending upward in dollar terms it means that the dollar is in a powerful bear market, not that gold and the SPX are simultaneously in bull markets.

An implication — as noted on the following chart — is that a gold bull market did not begin in December-2015. Gold cannot be in a bull market and at the same time be making new 10-year lows relative to the SPX, which is what it was doing until as recently as August-2018. At least, it can’t do that if a practical and sensible definition of “bull market” is used.

It’s possible that a gold bull market got underway in August-2018, but as mentioned above this has not yet been confirmed.

About five months ago I posted an article in response to stories that the Chinese government had pegged either the SDR-denominated gold price or the Yuan-denominated gold price. These stories were based on gold’s narrow trading range relative to the currency in question over the preceding two years, as if government manipulation were the only or the most plausible explanation for a narrow trading range in a global market. To illustrate the silliness of these stories I came up with my own story — that it was actually the Japanese government that was pegging the gold price. My story had, and still has, the advantage of being a better fit with the price data.

Just to recap, my story was that the Japanese government took control of the gold market in early-2014 and subsequently kept the Yen-denominated gold price at 137,000 +/- 5%. They lost control in early-2015 and again in early-2018, but in both cases they quickly brought the market back into line.

The following chart shows that they remain in control.

The narrow sideways range of the Yen gold price over the past 5 years is due to the Yen being the major currency to which gold has been most strongly correlated. The correlation is positive, meaning that the prices of gold and the Yen have a strong tendency to trend in the same direction. This is evidenced by the following daily chart, which compares the US$ price of gold with the US$ price of the Yen.

Moving from the fantasy world to the real world, the relationship depicted above doesn’t exist because the Japanese government is pegging gold to the Yen. It exists because both gold and the Yen trade like safe havens, meaning that they tend to do relatively well when economic growth expectations and the general desire to take-on risk are on the decline, and relatively poorly when economic growth expectations and the general desire to take-on risk are on the rise.

Gold trades like a safe haven because in part that’s what it is. The Yen is a piece of crap, but it trades like a safe haven due to the relentless popularity of Yen carry trades. These carry trades involve borrowing/shorting the Yen to finance long positions in higher-yielding currencies, and are a form of yield-chasing speculation. Periodically they have to be exited in a hurry to mitigate the losses caused by declining prices in the aforementioned high-yielding speculations. When this happens the Yen rallies, and sometimes the rallies are dramatic. Last week, for example.

Divergences or non-confirmations between gold and the Yen can create trading opportunities. However, the two markets are in line with each other at the moment, meaning that there is currently no divergence or non-confirmation worth trading.

The Fed probably will implement another 0.25% rate hike this week, but at the same time it probably will signal either an indefinite pause in its rate hiking or a slowing of its rate-hiking pace. The financial markets have already factored in such an outcome, in that the prices of Fed Funds Futures contracts reflect an expectation that there will be no more than one rate hike in 2019. However, this doesn’t imply that the Fed is about to stop or reduce the pace of its monetary tightening. In fact, there’s a good chance that the Fed unwittingly will maintain its current pace of tightening for many months to come.

The reason is that the extent of the official monetary tightening is not determined by the Fed’s rate hikes; it’s determined by what the Fed is doing to its balance sheet. If the Fed continues to reduce its balance sheet at the current pace of $50B/month then the rate at which monetary conditions are being tightened by the central bank will be unchanged, regardless of what happens to the official interest rate targets.

Another way of saying this is that a slowing or stopping of the Fed’s rate-hiking program will not imply an easier monetary stance on the part of the US central bank as long as the line on the following chart maintains a downward slope.

The chart shows the quantity of reserves held at the Fed by the commercial banking industry. A decline in reserves is not, in and of itself, indicative of monetary tightening, because bank reserves are not part of the economy’s money supply. However, when the Fed reduces bank reserves by selling securities to Primary Dealers (as is presently happening at the rate of $50B/month) it also removes money from the economy*.

I use the word “unwittingly” when referring to the likelihood of the Fed maintaining its current pace of tightening because, like most commentators on the financial markets and the economy, the decision-makers at the Fed are oblivious to what really counts when it comes to monetary conditions. They are labouring under the false impression that monetary tightening is effected mainly by hiking short-term interest rates and that the current balance-sheet reduction program is a procedural matter with relatively minor real-world consequences.

Therefore, over the next several weeks there could be a collective sigh of relief in the financial world as traders act as if the Fed has taken its foot off the monetary brake, followed by a collective shout of “oops!” when it becomes apparent that monetary conditions are still tightening.

*When the Fed sells X$ of securities to a Primary Dealer (PD) the effect is that X$ is removed from the PD’s account at a commercial bank and X$ is also removed from the reserves held at the Fed by the PD’s bank.

Apart from a 2-week period around the middle of the year, my Gold True Fundamentals Model (GTFM) has been bearish since mid-January 2018. There have been fluctuations along the way, but at no time since mid-January have the true fundamentals* been sustainably-supportive of the gold price. However, significant shifts occurred over the past fortnight and for the first time in quite a while the fundamental backdrop is now very close to turning gold-bullish. In fact, an argument could be made that it has already turned bullish.

Below is a chart comparing the GTFM (in blue) with the US$ gold price (in red).

The above chart understates the significance of the recent fundamental shift, because it appears that the GTFM has done no more than rise to the top of its recent range while remaining in bearish territory (which, of course, it has). However, a look beneath the surface at what’s happening to the GTFM’s seven individual components reveals some additional information.

The most important piece of additional information is the recent widening of credit spreads. The credit spreads input to the GTFM turned bullish four weeks ago, but since then it has moved a lot further into bullish territory. This has improved the fundamental situation (from gold’s perspective) without affecting the GTFM calculation.

Here is a chart showing the positive correlation between a measure of US credit spreads (the green line) and the gold/GNX ratio (gold relative to commodities in general). As economic confidence declines, credit spreads widen and gold strengthens relative to other commodities.

All things considered, for the first time in many months the true fundamentals appear to be slightly in gold’s favour. If the recent trend in the fundamental situation continues then we should see the gold price return to the $1300s early next year, but, of course, that’s a big if. Furthermore, even if the fundamental backdrop continues to shift in gold’s favour over the weeks ahead it will make sense for speculators who are long gold and the related mining equities to take money off the table when sentiment and/or momentum indicators issue warnings.

*Note that I use the term “true fundamentals” to distinguish the actual fundamental drivers of the gold price from the drivers that are regularly cited by gold-market analysts and commentators. 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 volume of gold being transferred out of the Shanghai Futures Exchange inventory, 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 aren’t true fundamental price drivers. At best, they are distractions.