I update gold’s true fundamentals* every week in commentaries and charts at the TSI web site, but my most recent blog post on the topic was on 30th April. At that time the fundamental backdrop was gold-bearish, but there has since been a change.

My Gold True Fundamentals Model (GTFM) turned bearish in mid-January 2018 and was still bearish at the end of the week before last (22nd June). There were fluctuations along the way, but at no time between mid-January and late-June was the fundamental backdrop supportive of the gold price. However, at the end of last week (29th June) the GTFM turned bullish. The deciding factor was a small, but significant, widening of credit spreads.

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

The upshot is that for the first time in more than 5 months the gold market has a ‘fundamental’ tail-wind, which is a prerequisite for a substantial rally. For reasons that I’ve mentioned in TSI commentaries I’m expecting a tradable 2-month rally from a July low rather than a substantial rally, but my expectations will change if the evidence changes.

*Note that I use the word “true” 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.

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

The article titled “Silver’s Critical Role In Electrification May Fuel Its Rise” contains some interesting comments about the silver market, but with one minor exception the information presented in this article has no bearing on silver’s risk/reward as a speculation or investment. The minor exception is the high (by historical standards) gold/silver ratio, which suggests that the silver price is likely to rise relative to the gold price over the next few years. However, none of the information about silver ‘fundamentals’ presented in the article is relevant to the silver price.

It isn’t relevant for the same reasons that most of the information presented by the ‘experts’ about gold fundamentals is also not relevant: It treats the annual output of the mining sector as if it were the total supply (annual mine production is a small fraction of the total supply) and it confuses flows from one part of the market to another with changes in total demand (every ‘flow’ involves an increase in demand on the part of the buyer and an exactly offsetting decrease in demand on the part of the seller). Furthermore, it isn’t relevant for another reason that can be illuminated by asking the question: within the past 80 years, when was there a major silver rally in the absence of a gold rally?

The answer is that over the past 80 years there hasn’t been a single major silver rally in the absence of a gold rally. The best rally in silver without a concurrent rally in gold was the 6-month price spike that began in Q3-1997. This rally resulted from an attempt to manipulate the price upward on the back of Warren Buffett’s silver accumulation; it did not result from any of the ‘fundamental’ drivers cited by commentators trying to make the case that silver can rally strongly without gold.

The historical record persuasively argues that large silver rallies don’t happen in the absence of large gold rallies. This tells us that either economic/financial-system confidence drives the silver market in the same way that it drives the gold market or that the big trends in silver simply follow the big trends in gold.

The bottom line is that there does not appear to be a good reason to expect the silver price to move substantially higher independently of the gold price.

[This post is an excerpt from a TSI commentary]

Conventional wisdom is that an inversion of the yield curve (short-term interest rates moving above long-term interest rates) signals that a recession is coming, but this is only true to the extent that a recession is always coming. A reversal in the yield curve from flattening to steepening is a far more useful signal.

What a yield curve inversion actually means is that the interest-rate situation has become extreme, but there is no telling how extreme it will become before the eventual breaking point is reached. Furthermore, although there was a yield-curve inversion prior to at least the past seven US recessions, Japan’s most recent recessions were not preceded by inverted yield curves and there is no guarantee that short-term interest rates will rise by enough relative to long-term interest rates to cause the yield curve to become inverted prior to the next US recession. In fact, a good argument can be made that due to the extraordinary monetary policy of the past several years the start of the next US recession will NOT be preceded by a yield curve inversion.

Previous US yield curve inversions have happened up to 18 months prior to the start of a recession, and as mentioned above it’s possible that there will be no yield curve inversion before the next recession. Therefore, we wouldn’t want to be depending on a yield curve inversion for a timely warning about the next recession or financial crisis. However, the yield curve can provide us with a much better, albeit still imperfect, recession/crisis warning in the form of a confirmed trend reversal from flattening to steepening. This was discussed in numerous TSI commentaries over the years and was also covered in a blog post last December.

There are two reasons that a reversal in the yield curve from flattening to steepening is a more useful recession/crisis warning signal. First, it is timelier. Second, it should work regardless of whether or not the yield curve becomes inverted.

Now, from a practical speculation standpoint it is not essential to understand WHY the yield curve reverses from flattening to steepening ahead of major economic problems bubbling to the surface. It is enough to know that it does. However, if you understand why the curve has reversed direction ahead of previous recessions you will understand why it either should or might not reverse direction in a timely manner in the future. After all, if extraordinary monetary policy could prevent the yield curve from becoming inverted ahead of the next recession then perhaps it also could prevent the yield curve from reversing course the way it has in the past.

With regard to understanding the why, the first point to grasp is that the boom phase of the cycle is characterised by borrowing short-term to lend/invest long-term. This puts upward pressure on short-term interest rates relative to long-term interest rates, meaning that it causes the yield curve to flatten. Also, when the boom is mature and is approaching its end there will be a scramble for additional short-term financing to a) complete projects that were started when monetary conditions were easier and b) address cash shortages that have arisen due to completed projects not delivering the predicted cash flows. This puts further upward pressure on short-term rates relative to long-term rates, and could, although won’t necessarily, cause the yield curve to become inverted.

Next, as the boom nears its end the quantity of loan defaults will begin to rise and the opportunities to profit from short-term leverage will become scarcer. Everything will still seem fine to casual observers, central bankers, the average economist and the vast majority of commentators on the financial markets, but it will now be apparent to a critical mass of astute operators (investors, speculators and financiers) that many of the investments that were incentivised by years of easy money were ill-conceived. These operators will begin shifting towards ‘liquidity’ and away from risk.

The aforementioned increasing desire for the combination of safety and liquidity leads to greater demand for cash and gold. But more importantly as far as this discussion is concerned, it boosts the demand for short-term Treasury debt relative to long-term Treasury debt (thus putting downward pressure on short-term interest rates relative to long-term interest rates). The reason is that the shorter the term of the Treasury debt, the lower the risk of an adverse price movement. For example, if you lend $10B to the US government via the purchase of 3-month T-Bills then in three months’ time you will have something worth $10B, but if you lend $10B to the US government via the purchase of 10-year T-Notes then in three months’ time you could have something that is worth significantly more or less than $10B.

As an aside, what an investor focused on boosting liquidity really wants is cash, but if he has billions of dollars then cash is not a viable option. This is because the cash would have to be deposited in a bank, which means that the investor would be lending the money to a bank and taking the risk of a massive loss due to bank failure. Lending to the US government is a much safer choice.

In summary, it’s mainly the desire for greater liquidity and safety that begins to emerge at the tail-end of a boom that causes the yield curve to stop flattening and start steepening. As demonstrated by the events of the past few years the central bank has substantial power to postpone the end of a boom, but eventually a breaking point will be reached and when it is the yield curve’s trend will change from flattening to steepening.

The term “fiat” is often associated with irredeemable-paper or electronic currency, but existing only in paper or electronic form is not the defining characteristic of fiat currency. In fact, paper or electronic currency is not necessarily “fiat” and hard commodity currency can be “fiat”.

Regardless of the form it takes, fiat currency is simply currency by government decree. If the government dictates that a certain ‘thing’ is money and must be accepted in payment for goods, services and debts, then that ‘thing’ is a fiat currency.

Obviously, all of today’s national currencies are fiat currencies. Not so obviously, gold was a fiat currency during the Gold Standard era. It could be claimed — without any argument from me — that during the Gold Standard era gold would have been the most widely used currency without the government making it so, but this is beside the point. In the situation where the government has commanded that gold is money, gold is a fiat currency.

Also not so obviously considering what has been written on the topic in other places, Bitcoin is not a fiat currency. If anything it is the opposite of a fiat currency, because it was created by the private sector and is not supported in any way by the government. This doesn’t mean that Bitcoin is a good currency, as there is a lot more to being a good currency than being outside the direct control of government.

Summing up, people should be careful when applying the word “fiat” to currency/money. The word is routinely used to mean irredeemable or non-physical, but that’s not what it actually means.