Although it is not possible to determine an objective value for gold (the value of everything is subjective), by looking at how the metal has performed relative to other things throughout history it is possible to arrive at some reasonable conclusions as to whether gold is currently expensive, cheap, or ‘in the right ballpark’. In particular, gold’s market price can be measured relative to the prices of other commodities, the stock market, the price of an average house, the earnings of an average worker, and the real (purchasing-power-adjusted) money supply. In a recent TSI commentary I looked at the last of these, that is, I looked at gold’s price relative to the real money supply, and arrived at the conclusion that gold’s current price was about 20% above ‘fair value’. I’ll now take a look at gold relative to other commodities.

As illustrated below, over the past 20 years — with the exception of a short-lived spike in 2011 — major swings in the gold/silver ratio have bottomed at around 45 and peaked at around 80. The ratio is currently near the top of its 20-year range, which means that gold is expensive relative to silver.

As a consequence, to argue that there has been a successful long-term price suppression scheme in the gold market you must also argue that there has been a successful long-term price suppression scheme in the silver market. Such arguments have, of course, been put forward, with one analyst claiming that JP Morgan has managed to do the impossible by amassing a large long position in physical silver while simultaneously suppressing the price of silver by selling futures contracts.

The next chart shows that gold is also near a 20-year high relative to platinum, the implication being that gold is expensive relative to platinum.

Consequently, to argue that there has been a successful long-term price suppression scheme in the gold market you must also argue that there has been a successful long-term price suppression scheme in the platinum market. Again, such arguments have been put forward. For example, one analyst has suggested that the daily platinum ‘fix’ in the London market was used to manipulate the price downward over the long-term, even though there was an overall upward bias in the price over the period under analysis. For another example, an analyst has argued that the platinum price has been persistently reduced by the short-selling of platinum futures, an outcome that would only be plausible if every sale of a futures contract didn’t subsequently have to be closed-out via the purchase of a contract and if automotive companies had figured out a way to replace the physical platinum used in catalytic converters with paper contracts.

The final chart shows that gold is presently near an all-time high relative to the CRB Index (an index representing a basket of 17 commodities). This chart therefore shows that gold is expensive relative to commodities in general.

As far as I know, nobody has yet tried to argue that the prices of most commodities are being suppressed as part of a grand plan to conceal the long-term suppression of the gold price. Instead, gold’s expensiveness relative to commodities in general is studiously ignored.

To summarise the above: gold is currently expensive relative to many other commodities.

Almost regardless of what gold is measured against, it does not look cheap at this time. However, given what is happening to money and economies around the world, there is logic to the fact that gold is relatively expensive right now. Also, it is logical to expect that gold is going to get a lot more expensive within the next few years.

As I’ve explained in the past, gold is not now and has never been a play on “CPI inflation”. Of course, on a very long-term (multi-generational) basis the gold price will tend to rise by enough to offset the decline in the purchasing power of money, but so will the prices of many other assets. What makes gold special is that it is the premier long-term hedge against bad monetary and fiscal policies.

Gold isn’t cheap right now, but in a world that is rife with bad monetary and fiscal policies it is destined to become a lot more expensive.

Due to the confiscation of gold by the Roosevelt Administration in 1933, there remains an undercurrent of concern among gold owners that the US government or another major government will confiscate gold in the future. However, the risk of this happening is presently so low as to not be worth taking into account. Of far greater risk are capital controls and the confiscation of cash.

Gold confiscation is not a realistic threat under the current monetary system, because under the current system gold isn’t money. To further explain, the reason that gold was confiscated in the US in 1933 was that gold, at that time and place, was money, with the dollar essentially being a receipt for gold. Consequently, the amount of gold in the banking system placed a limitation on the quantity of dollars. By making gold ownership illegal the US government not only prevented the public from removing gold from the banking system, thus eliminating one of the superficial deflationary forces, it also pushed additional gold into the banking system and paved the way for greater monetary inflation.

Today, gold imposes no limitations on the abilities of the government and its agents to spend, borrow and inflate, so there is no reason for the government to confiscate it or even to care about it.

As an aside, in the 1930s the US government confiscated silver shortly after it confiscated gold, even though silver wasn’t official money at the time. However, the primary reason for the silver confiscation was the same as the reason for the gold confiscation — to pave the way for greater monetary inflation. As part of an effort to increase the money supply, the confiscated silver was put directly into the monetary base by turning it into legal tender in the form of coins or silver certificates. The 1934 silver nationalisation order actually brought silver back into the monetary system, where it remained until the early-1960s.

What the government wants to control is the official money, which in 1933 was gold and today is the dollar or some other fiat currency. The government is therefore focused on monitoring/controlling the flow of today’s currency units, which means that you are at far greater risk of having your cash confiscated or restricted in some way than having your gold confiscated.

Moreover, capital controls aren’t just a potential future problem, they exist in almost every country today. In almost every country there are already restrictions on a) the transfer of money across national borders, b) the transfer of money between different account-holders, and c) the amount of deposit currency that can be converted to physical cash. If these aren’t capital controls by another name, what are they?

Capital controls are likely to become more draconian over time. People with significant financial assets should therefore already be managing the capital-controls risk by diversifying their assets internationally*. Also, everyone (especially US citizens), including those who don’t yet have significant financial assets to protect, should have a second passport as a guard against future restrictions on freedom.

*If you are concerned about gold confiscation then you could also manage this risk by distributing your gold across vaults in different countries. This is easy to do via Bullionvault.com or the new BitGold service.

According to the fellow in the video shown below, the Chinese are invading Australia. It isn’t a military invasion, it’s an economic invasion that involves the buying-up of Australian real estate and has caused young Australian families to be priced out of the property market. The solution, apparently, is for the Australian federal government to stop turning a blind eye to this flood of foreign investment and, instead, to put a stop to it, thus resuscitating the “Australian dream”. Unfortunately, the star of the video is both ethically and economically wrong. He is ethically wrong because he is advocating the widespread violation of property rights (he wants the government to dictate who Australian property owners can sell to, with the particular aim of preventing the sale of property to buyers who live in China), but it’s the economic error I’m going to deal with in this post.

Our ‘the-government-oughta-do-something-to-stop-the-Chinese-real-estate-invasion’ protest organiser and You-Tuber is unaware of two important economic realities, the first and lesser important of which is that Australia runs a large current-account deficit. This deficit, which comprises dividend payments, interest payments on foreign debt and a surplus of imports over exports, is running at around A$40B per year. This means that about $40B per year is ‘flowing’ out of the country on the current account, which means that about $40B/year of new investment MUST flow into the country (since nobody has any use for Australian dollars outside Australia). In other words, the current account deficit necessitates $40B per year of net foreign investment, approximately a quarter of which goes into real estate.

The more important economic reality of which our irrepressible video presenter is unaware is Australia’s rapid rate of monetary inflation. Thanks to the activities of the Reserve Bank of Australia (RBA) and the commercial banks, the supply of Australian dollars has risen by 13% over the past 12 months and 44% over the past 4 years. With this rate of money-supply growth and low interest rates it is no wonder that houses have become very expensive. With this monetary backdrop, houses would almost certainly have become very expensive even if China didn’t exist. Furthermore, a rapid rate of monetary inflation tends to increase the current account deficit and weaken the currency on the foreign exchange market, thus putting more of the currency in the hands of foreign investors and simultaneously making domestic property prices look cheaper to foreign investors.

So, if the guy in above video had a better understanding of economics he’d be organising a protest outside the RBA headquarters instead of the Chinese consulate.

The title of this post refers to the debate between Jeff Clark and Harry Dent about gold’s prospects over the next 2 years, with Harry Dent arguing for a collapse in the gold price to less than $700/oz and Jeff Clark arguing in favour of a bullish outcome. I put inverted commas around the word great, because neither participant in this debate made a good argument. However, while the Clark side of the debate could have been a lot better, the Dent side was a stream of complete nonsense. In this post I’ll deal with a couple of the flaws in Dent’s analysis and also briefly address the extremely persistent deflation fantasy that lies at the core of Dent’s latest big prediction*.

An important point to understand is that gold is not now, and has never been, a play on “CPI inflation”. As I stated in an earlier post: “Gold is a play on the economic weakness caused by bad policy and on declining confidence in the banking establishment (led by the Fed in the US). That’s why cyclical gold bull markets are invariably born of banking/financial crisis and/or recession, and why a cyclical gold bull market is more likely to begin amidst rising deflation fear than rising inflation fear.” Jeff Clark barely touches on this key point, while Harry Dent believes that the point is invalidated by the fact that the gold price fell by 33% during part of the 2008 financial crisis.

Harry Dent keeps returning to gold’s performance during 2008 and provides no other historical examples of gold performing poorly in times of financial crisis. He therefore either has very little knowledge of gold’s historical record or he believes that hundreds of years of history were negated by what happened during 2008. Either way, he is misinformed, because gold outperformed the US$ over the course of 2008. The 33% decline is from the best level of the year to the worst level of the year, but even this sizeable peak-to-trough loss was fully eradicated by the first quarter of 2009. Moreover, if we consider the entire Global Financial Crisis (GFC), with the 10th October 2007 closing high for the S&P500 marking its beginning and the 10th March 2009 closing low for the S&P500 marking its end, we find that gold gained 24% in US$ terms and 34% in euro terms over the course of the crisis.

Information that must always be taken into account when assessing gold’s performance in reaction to events is the gold-price starting point. The reason that gold was initially hit hard in US$ terms during the general market crash of 2008-2009 is largely due to the US$ gold price being ‘overbought’ and at a multi-decade high just prior to the crash, which is obviously not the case today. Furthermore, as I mentioned above it quickly recouped its losses.

And information that must be taken into account when assessing the performances of all the financial markets during the GFC of 2007-2009 is that the Fed did not begin to pump-up the US money supply (properly measured via TMS) until September of 2008. From September of 2007 through to August of 2008 the Fed cut interest rates, but the monetary inflation rate remained at a low level. Since there is no longer any scope to cut interest rates, it’s a virtual certainty that the Fed’s initial response to a deflation scare in the not-too-distant future would involve ramping-up the money pumps.

In addition to presenting gold’s GFC performance in a misleading way, there are numerous problems with Dent’s argument. Due to time constraints I’m only going to deal with one of them. Here’s the relevant excerpt:

“The gold bug camp is constantly telling us that governments are debasing our currency, especially the almighty US dollar and destroying the value so that the dollar is not a good store of value. I 100% disagree.

Here’s an analogy to explain: Since its invention in 1971, the microchip has been multiplied by the trillions, creating a revolution in human communications. Its evolution is a crystal-clear sign of progress and of a higher standard of living. Translating that back to the dollar argument, if the exponential multiplication of the microchip was (is) a good thing, why would the multiplication of dollars not also be a sign of progress that similarly fosters a revolution in urbanization, more complex and rich specialization of skills, and an improved standard of living? Increasing urbanization leads to rising affluence and the need for greater dollars for transactions in a more complex urban society!”

This may be the stupidest economics-related comment I’ve ever read from a trained economist, which is saying something considering the competition. It implies that he doesn’t know the difference between a rise in the quantity of the medium of exchange and a rise in the quantity of real wealth. It implies that he sees no difference between the private sector increasing the supply of labour-saving or life-sustaining or life-enhancing products and central banks creating new money out of nothing. Also, he apparently perceives the factual decline in the US dollar’s purchasing power as a goldbug delusion.

Harry Dent should not be taken seriously, but the view that deflation is coming should not be dismissed out of hand. Also, it is possible to make a legitimate gold-bearish argument, it’s just that Harry Dent hasn’t done it.

Under the current monetary system and the theories that dominate central banking, true deflation — such as occurred in the US during 1930-1932 — has a near-zero probability of happening. In the future there could (almost certainly will) be changes to the monetary system and/or the political environment that pave the way for true deflation, but that’s not something that has a realistic chance of happening over the next two years. In the meantime, there will probably be another deflation scare.

While it’s in progress a deflation scare will look and feel like 1930s-style deflation to most people. The difference is that you don’t get the economic ‘reset’ that would be caused by true deflation. Instead, policy-makers react to the scare by 1) aggressively injecting new money into the economy, 2) ensuring that the total volume of credit continues to grow, and 3) generally doing whatever it takes to prop-up prices. In doing so they add new imbalances to the existing imbalances.

Deflation scares are very bullish for gold. That’s why the deflation scare of 2001-2002 set in motion a large multi-year advance in the gold price and why the deflation scare of 2007-2009 set in motion a large multi-year advance in the gold price. If another deflation scare gets underway this year then so, in all likelihood, will another large multi-year advance in the gold price.

Looking out over the coming 1-2 years, the risk for gold isn’t that there will be true deflation, because that’s a virtual impossibility under the current monetary set-up. Nor is the realistic possibility of a deflation scare a risk for gold, since such a development would create a very gold-bullish fundamental backdrop. Rather, the risk for gold is a continuation of the monetary-inflation-fueled boom of the past few years.

In effect, the main risk for gold is an economic outcome that is almost the OPPOSITE of what Harry Dent is predicting.

*Harry Dent’s modus operandi is to come out with a new ‘big prediction’ almost every year. This creates a media buzz that facilitates the sale of books. If a big prediction doesn’t pan out, no problem — just make another one. Eventually, one will hit the mark. In the early-1990s he got lucky and correctly predicted the ensuing boom (it was blind luck because his reasoning was wrong). If he gets lucky again, he’ll have a track record to shout from the hilltops.

Assuming that useful price clues are what you want, it’s pointless to analyse the flow of gold into China and within China. I explained why HERE, HERE and HERE. I’ll write about the bogus ‘China gold demand’ theory again in the future as it’s one of the most persistent false beliefs within the bullish camp, but in this post I’m going to quickly deal with another China-related false belief that periodically shifts to the centre of the bullish stage: the idea that China’s government is preparing to back the Yuan with gold.

I was going to write in detail about why a gold-backed Yuan is a pipe dream, but then I discovered Geoffrey Pike’s article on the same topic and realised that doing so would be akin to reinventing the wheel. This is because the aforelinked article encapsulates the argument I would have attempted to make. You should click on the link and read the entire piece (it isn’t long), but here’s the conclusion:

“There is no way that the Chinese central planners are going to voluntarily give up an enormous amount of power by going to some form of a gold standard. It would drastically reduce their ability to spend money. It would reduce their power. It would limit their ability (or lack of) to centrally plan the economy.”

Given that there are good reasons to expect gold to resume its long-term bull market in the not-too-distant future, why do so many bullish gold analysts argue their cases using the equivalent of fairy stories?

During the week since I first wrote about BitGold (XAU.V) the stock price has been on a wild ride. It went from C$4.14 up to C$8.00, down to C$4.50, up to C$6.50, and ended the 25th May trading session at C$5.60. At C$5.60/share and with a new (post-acquisition) share count of around 50M, the company has a market cap of roughly C$280M (US$230M). The product appears to be excellent from the perspective of customers, but is the business really worth US$230M?

Let me ask the above question in a different way. With its current fee structure and likely user base it’s possible that BitGold will never be consistently profitable and cash-flow positive. If a business does not have a good chance of ever being consistently profitable or cash-flow positive, what’s it worth?

As a standalone enterprise it is worth very little, especially considering that the company in question could run into regulatory problems after it puts its debit card into operation (this is the point at which governments will start taking a keener interest). However, it could be worth a lot to another company if the money-losing business is complementary to the acquirer’s existing business. For example, companies such as Google and Facebook have paid huge sums (billions of dollars) for businesses that would likely never be consistently profitable as standalone enterprises. They’ve done so because of the value that these businesses would potentially add to the existing Google and Facebook operations.

In any case, I doubt that anyone who has bought BitGold shares at prices above C$4 has done a realistic calculation of the business’s value as either a standalone enterprise or as an add-on to a larger financial services company. Actually, very few of the buyers would have done any calculation of value whatsoever. Instead, they would have bought because they like the idea of BitGold, oblivious to the fact that a good business can be a bad investment at the wrong price, or because they think that someone else will be dumb enough to pay an even higher price in the future.

Moving on, I’m impressed by the company’s senior managers. They did a terrific job of setting up an electronic gold-trading/payment platform, because the system, although simple from a customer’s perspective, is complex. In addition, they have done a fine job to date of whipping up enthusiasm for the stock and they demonstrated financial acumen by using the over-valued shares to make a big acquisition.

The big acquisition I’m referring to is the purchase of GoldMoney.com (GM), a company founded by James Turk, for about C$50M in XAU shares. GM was originally designed to do what BitGold is now planning to do, although it has since turned into a precious-metals dealing and storage service (it provides a cost-effective way for people to buy, hold and sell gold and other PMs without the hassle of taking delivery).

The first press release announcing the acquisition of GM was issued prior to the start of North American trading last Friday and was very misleading. Almost no financial details of the GM business were provided and the information that was provided created a false impression. Canada’s stock-market regulators obviously picked up on this, as the company’s plan to have its shares re-open for trading last Friday morning (the stock had been halted pending the news) had to be abandoned while it put together a new press release containing more details of what it was buying. This second attempt also appears to have been deemed unacceptable by the regulators, however, so the stock remained halted and a third press release announcing the GM acquisition was put out on Monday morning. The third time was the charm and the stock resumed trading around mid-day on Monday 25th May.

The financial details provided in the final press release revealed that GM’s business was shrinking at a rapid pace, that GM had generated only $5M of cash flow in its best year (2011), and that it was cash-flow negative over the past two years.

It’s unlikely that GM’s 135,000 current users will be significantly more profitable as part of BitGold than they were as part of GM.

I’m yet to read a proper valuation analysis (one that uses realistic assumptions) that demonstrates why BitGold deserves a multi-hundred-million-dollar market cap. Actually, I’m yet to read any proper valuation analysis from the bulls. According to the bullish articles I’ve read, you should simply buy the stock because the product is a great idea and the company’s founder is very smart. It’s as if there is no limit to what you should pay for an investment as long as there is a good story behind it. The bulls on the stock also point out that some big-name investors have taken significant BitGold positions. This is true, but the big-name investors generally paid C$0.90/share or less for their stakes. I could be wrong, but I doubt that they are interested in buying near the current price.

I don’t want it to seem as if I’m on some sort of crusade against BitGold. I very much want the business to succeed, because I like the product and want it to remain available. My only issue is with the stock’s valuation.

Even if the product makes great strides in popularity, with its current fee structure the underlying company will always be a low-margin business and therefore deserving of a low valuation. This, of course, doesn’t guarantee that the stock’s valuation won’t go a lot higher than its current elevated level, given the public’s proven ability to ignore valuation for long periods. There is also a chance that if BitGold can grow its customer base into the millions then it will be worth a lot to another electronic payment company such as PayPal or Mastercard, even if the BitGold business is a consistent money-loser. That’s one reason I definitely wouldn’t want to be short the stock and why, in terms of practical stock-market speculation (my primary source of income), I have no desire to get involved. Instead, I’ll continue to watch from the sidelines with detached amusement.

Summing up, my concern is that at some unknowable future time the “it’s a great product with smart management therefore the stock should be bought at any price” bubble of enthusiasm will collide with the “it will always be a low-margin business and therefore deserves a low valuation” brick wall of reality.

Although the evidence is far from conclusive, when taken together a number of price-related developments since the beginning of this year suggest that the cyclical commodity bear market has ended. I’m are referring to the extent to which prices fell during the second half of last year (the decline has the look of a final, bear-market-ending capitulation), the fact that oil is trading in line with a pattern that has marked multi-year bottoms in the past, the upward reversal in the Canadian Dollar, the turn from relative weakness to relative strength in emerging-market equities, and the strong rebounds in Russia’s stock market and currency. I’ll now zoom in on the last two of these developments.

The first of the following weekly charts compares the EEM/SPY ratio (the Emerging Markets ETF relative to the S&P500) with the CRB Index (an index comprising the prices of 17 commodities). The blue line on the top section of the chart is EEM/SPY’s 70-week MA. The EEM/SPY ratio trends in the same direction as the CRB Index and generally leads the CRB Index at major turning points, with trend reversals confirmed by EEM/SPY breaking above/below its 70-week MA.

The EEM/SPY ratio has turned upward. It hasn’t yet broken above its 70-week MA, but the reasons to expect that a reversal will be confirmed within the next few months are the extremely depressed level from which the CRB Index is rebounding and the second of the following charts.

The second chart compares the RSX/EEM ratio (Russian equities relative to Emerging-Market equities) with the CRB Index. When commodity prices are in an upward trend, Emerging-Market equities are generally strong relative to US equities and Russian equities are generally strong relative to Emerging-Market equities. In other words, Russian equities (in US$ terms) tend to be very strong on a relative basis. It works this way almost regardless of what’s happening in Russia.

The RSX/EEM ratio just had its strongest rally in more than 4 years and the rally happened in parallel with widespread pessimism about Russia’s economic prospects. This is a sign that the commodity bear market is over.

This post is a modified excerpt from a recent TSI commentary.

The following table shows the amount of monetary inflation in a number of different countries/regions. Specifically, the table shows the amount by which the money supplies of Australia, China, the Euro-Zone (EZ), Hong Kong, Japan, the UK and the US have grown over the past year, the past 2 years and the past 4 years. In those cases where it was easy for me to do the calculation I’ve used TMS (True Money Supply) as the monetary aggregate, but in other cases I’ve used M1 or M2. In China’s case I show results for both M1 and M2, because due to the lack of detail provided by the People’s Bank of China I’m not sure which of these measures is closest to TMS.

Here’s some information that can be gleaned from the above table:

1) Japan continues to have a relatively slow rate of monetary inflation, despite popular opinion to the contrary. In particular, although it has now been 2 years since the BOJ began to implement the greatest QE program in world history, over the past 2 years Japan’s money supply has only increased by 7.1%. This compares to 2-year increases of 16.4% for the US, 18.2% for Europe and 26.9% for Australia. How much longer will the general perception of what’s happening in Japan diverge from the reality of what’s happening in Japan?

2) The rate of monetary inflation in the EZ is accelerating relative to the rates of monetary inflation elsewhere. That’s why the table reveals that the 12-month rate of inflation in the EZ is now second-only to that of Australia. Furthermore, if the table showed growth figures for the past 6 months it would reveal that the EZ is now leading by a wide margin in the race to inflate (a.k.a. the race to the bottom).

3) Although its M2 money supply is still growing at close to 10%/year, there has been a significant tightening of China’s monetary conditions over the past 18 months. This is — at least in part — both a cause and an effect of the deflation of the country’s property bubble. It seems that in a command economy where non-performing loans never have to be recognised as such, it is possible for a massive credit-fueled investment bubble to deflate gradually.

4) The supply of Hong Kong dollars has increased by 54% over the past 4 years. This monetary inflation and the mimicking of US interest-rate policy, both of which are required to maintain the HK$-US$ peg, explain Hong Kong’s real estate bubble and high cost of living. The HK$-US$ peg hasn’t made sense for a long time and has become the main cause of a huge inflation problem in Hong Kong.

5) Considering the relatively fast pace of Australia’s money-supply growth and the A$’s resulting over-valuation, it’s remarkable that the A$’s exchange rate stayed so high for so long. The reason it didn’t buckle sooner is that the commodity price trend tends to overwhelm all other influences on the A$’s trend. This is illustrated by the following chart of the A$ and the Continuous Commodity Index Fund (GCC). An implication is that almost regardless of its inflation rate, the A$ will turn higher at around the same time as the general commodity price trend turns higher, which, by the way, probably just happened or will happen within the next few months.

A popular view is that gold has no monetary role to play in a modern, technologically-advanced economy. This view is wrong in many ways, including that, thanks to technological advances, gold is now better suited to being money than it has ever been. This is because technology has eliminated the inconveniences that would otherwise limit gold’s usefulness as money, with BitGold being the latest evidence.

In a TSI commentary back in 2010, here’s how I summarised the reason that gold is better suited to being money today than it ever has been in the past: “[The key is that] technology [now] allows gold ownership to simply and instantly be transferred without the need to physically move bullion. Almost all the monetary gold could remain locked in vaults, with ownership to a quantity of gold — anywhere from a tiny fraction of a gram to many kilograms, depending on what is being purchased — being effected electronically.” Previous attempts have been made to create platforms that enable gold to be a convenient medium of exchange, with ownership instantly transferred electronically when a transaction is done, but BitGold is the first attempt that stands a good chance of being successful.

The choice of the name “BitGold” was obviously influenced by the growing popularity (and notoriety) of Bitcoin, but BitGold and Bitcoin have almost nothing in common aside from being ways to store purchasing power and make electronic payments outside the banking system. Importantly, BitGold doesn’t have Bitcoin’s flaws, the most serious of which is that a Bitcoin, like a dollar or a Yen or a Ruble, has no use outside of its role as a medium of exchange.

Rather than being an electronic medium of exchange itself, BitGold is a platform for trading a substance (gold) that has historically been the world’s premier medium of exchange. Putting it another way, users of the BitGold system are not trading computer ‘bits’, they are trading ownership to specific pieces of physical gold stored in a vault.

To be fair, Bitcoin has one significant advantage over BitGold. The beauty of Bitcoin is total decentralisation. There are no intermediaries. There is also no need to jump through the personal ID (Know Your Customer) hoops established by the banking system at the behest of government. With BitGold there are intermediaries (vaults and insurance companies), and all the usual banking-system requirements apply.

As far as I can tell, there is no way to use technology to quickly/efficiently transfer ownership of gold without using intermediaries responsible for storing the gold and keeping it safe. On the plus side, with BitGold the storage is outside the banking system and there are several options regarding geographical location.

I’m not going to explain all the benefits of BitGold and how it works, because that’s already been done in a number of places on the internet. For example, Bob Moriarty provides a good overview HERE. I like BitGold, the product, a lot, and will probably open an account in a couple of months if it operates smoothly during the intervening period. But BitGold, the stock, is a different kettle of fish.

BitGold shares (TSXV: XAU) listed at the same time as the company opened its virtual doors to customers. This is strange. Normally, a company will have operating history before it lists on a stock exchange. Was it a deliberate ploy to float the company on the stock market before there were any hard data that could be used to value the shares? If so it worked, because the shares immediately attained what appears to be a very high valuation. I say “appears to be” in the previous sentence because, with no operating history to go by, it is impossible to even guesstimate what the company is worth. What I can do, however, is roughly determine the amount of success built into the current stock price.

At last Friday’s closing price of C$4.14 and with around 37M shares outstanding, XAU’s market cap is C$153M. This equates to US$126M at the current exchange rate. How many users would BitGold need to justify this market cap?

BitGold makes money on transaction volume — on the purchase/sale of gold. Specifically, it takes 1% of every purchase and every sale of gold made through the BitGold system. Users of the BitGold system are not charged anything for gold storage and insurance, meaning that all costs of running the system must come out of the aforementioned 1% and that whatever is left becomes BitGold’s gross profit. For the purposes of this exercise I’m going to ignore these costs and make the assumption that due to its strong growth potential the company is worth 10-times its annual sales revenue. Based on this assumption, the current market cap of US$126M would be justified by annual sales of roughly US$13M. To get $13M of sales, BitGold would need annual transaction volume of US$1.3B.

Now, the company guesses that its average annual transaction volume per user will be $1000-$2000. If I divide this range into the $1.3B implied by the current market cap, I get a range of 650K-1.3M. In other words, this method of valuation suggests that the current share price is discounting a customer base in the 650K-1.3M range.

As an aside, it is clear that BitGold will need a fairly high average transaction volume per user to be meaningfully profitable. However, it’s a good bet that many of the users will initially be ‘goldbugs’ who will use the service to make long-term investments in physical gold. Based on its current fee structure, BitGold would be more likely to lose money than make money from this type of customer.

Taking another valuation approach, BitGold has been likened to PayPal so perhaps it would make sense to compare BitGold’s valuation to PayPal’s valuation. PayPal is apparently being valued at $84 per user, but there are three reasons — not even taking into account the fact that PayPal is a major success while BitGold’s success is not yet assured — that BitGold’s valuation should be significantly lower than PayPal’s. The first is that PayPal has no storage and inventory costs to absorb. The second is that PayPal is solely a vehicle for transferring a medium of exchange whereas many of BitGold’s customers will use the service for store-of-value purposes*. The third is that the BitGold service is not available to US citizens. I’ll therefore assume that BitGold’s per-user value is a little lower than PayPal’s.

Assuming $70/user, BitGold’s current market cap implies a user base of 1.8M.

Based on the valuation methods outlined above and the company’s own growth projections, it seems to me that if all goes well then BitGold could grow into its CURRENT market cap in 2-3 years. This means that great success has already been priced in, leaving plenty of risk and no valuation-related upside for new buyers of the shares. Of course, there will always be upside potential due to the pool of greater fools, especially considering that the supply of XAU shares is small at this time.

The bottom line is that BitGold, to me, is like Amazon.com: I love the product, but hate the stock’s current valuation.

*Gresham’s Law is an obstacle to BitGold’s profitability, in that the sort of people who would want to own physical gold would be more likely to spend their fiat currency than their gold. That is, they would tend to hoard their gold and spend their dollars, euros, etc., thus reducing BitGold’s revenue per user.

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?

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.

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.

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.

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.

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.

The Bloomberg article posted HERE reports that after a decade-long 5-times increase, the worldwide stash of foreign currency reserves held by central banks has begun to shrink. Is this good, bad, or irrelevant?

The answer is no — it’s not good, it’s not bad, and it’s not irrelevant. To be more accurate, it would be good if it indicated a new long-term trend, but it almost certainly doesn’t indicate this. Instead, it is just part and parcel of the way the current monetary system works.

The key to understanding the implications of global reserve changes is knowing that these changes are mostly driven by attempts to manipulate exchange rates.

During the first stage of a two-stage cycle, many central banks and governments perceive that their economies can gain an advantage by weakening their currency on the foreign exchange market. Although it is based on bad theory, this perception is a real-world fact and often guides the actions of policy-makers. It prompts central bankers to buy-up the main international trading currency (the US$) using newly-printed local currency, resulting in the build-up of foreign currency reserves, growth in the local currency supply, and an unsustainable monetary-inflation-fueled boom in the local economy.

The build-up of foreign currency reserves during the first part of the cycle is therefore not a sign of strength; it is a sign of a future “price inflation” problem and a warning that the superficial economic strength is a smokescreen hiding widespread malinvestment.

During the second stage of the cycle the bad effects of creating a flood of new money to purchase foreign currency reserves and manipulate the exchange rate become apparent. These bad effects include economic weakness as investing mistakes become apparent, as well as uncomfortably-rapid “price inflation”. Pretty soon, policy-makers in the ‘reserve-rich’ country find themselves in the position of having to sell reserves in an effort to arrest a downward trend in their currency’s exchange rate — a downward trend that is exacerbating the local “price inflation” problem. This is the situation in which many high-profile “emerging” economies have found themselves over the past two years, with Brazil being one of the best examples.

In other words, the world is now immersed in the stage of the global inflation cycle — a cycle that’s a natural consequence of today’s monetary system — in which reserves get disgorged by central banks as part of efforts to address blatant “inflation” problems. This would be a good thing if it indicated that the right lessons had been learned from past mistakes, leading to a permanent change in strategy. However, that’s almost certainly NOT what it indicates.

The disturbing reality is that at some point — perhaps as soon as this year — a large new injection of money will be seen as the solution, because bad theory still dominates. As evidence, I cite two comments from the above-linked article. The first is by the author of the piece, who implies in the third paragraph that emerging-market countries need to boost their money supplies to shore-up faltering economic growth. The second is from a former International Monetary Fund economist and current hedge-fund manager, who claims via a quote in the fourth paragraph that emerging markets now need more stimulus.

So, emerging-market economies have severe problems that can be traced back to earlier monetary stimulus, but the solution supposedly involves a new bout of monetary stimulus. Let the idiocy continue.

At TSI over the past year and at the TSI Blog two months ago I’ve made the point that the Fed gave itself the ability to pay interest on bank reserves so that the Fed Funds Rate (FFR) could be raised without the need to shrink bank reserves and the economy-wide money supply. I explained that the driver of this change in the Fed’s toolbox was the fact that the massive quantity of reserves injected into the banking system by QE (Quantitative Easing) meant that it would no longer be possible for the Fed to hike the FFR in the traditional way, that is, via the sort of small-scale shrinkage of bank reserves that was used in the past. Instead, the quantity of reserves has become so much larger than would be required to maintain a Funds Rate of only 0.25% that even a tiny increase to 0.50% would necessitate a $1 trillion+ reduction in reserves and money supply, which would crash the stock and bond markets. The purpose of this post is to point out that while the payment of interest on bank reserves is now the Fed’s primary tool for implementing rate hikes, there are two other tools that the Fed will use over the years ahead in its efforts to manipulate short-term US interest rates and distort the economy.

Before going any further I’ll note that it isn’t just logical deduction that led to my conclusion regarding the purpose of interest-rate payments on bank reserves. It happens to be the only conclusion that makes sense, but it’s also the case that the Fed, itself, has never made a secret of why it started paying interest on reserves. The Fed’s reasoning was reiterated in a 27th February speech by Vice Chairman Stanley Fischer. A hat-tip to John Mauldin and Woody Brock for bringing this speech to my attention.

The two other tools that will be used by the Fed to raise the official overnight interest rate are Reverse Repurchase agreements (RRPs) and the Term Deposit Facility (TDF). The RRP isn’t a new tool, but its importance has increased and will continue to do so. The TDF is a relatively new tool, having been introduced on a small scale in 2010 and having been expanded in 2014.

The RRP is used by the Fed to borrow reserves and money for short periods, with securities (bonds, notes or bills) from the Fed’s stash being used as collateral for these borrowings. Now, an institution that has the unlimited ability to create new money can never run short of money and will therefore never need to borrow money to fund its operations, but the Fed sometimes borrows money via RRPs as part of its efforts to manipulate interest rates. Specifically, by offering to pay financial institutions a certain interest rate to borrow reserves and money, the Fed pressures the effective interest rate towards its target.

The TDF is similar to a normal money-market account, except that it is provided by the Fed and can only be used by depository institutions. The term of the deposit is currently up to 21 days and the interest rate paid is slightly above the rate paid on bank reserves.

Further to the above, when the Fed eventually decides to hike the Fed Funds Rate it will not do so by reducing the quantity of bank reserves. The quantity of bank reserves will probably decline as part of the rate-hiking process, but the quantity of reserves in the banking system is now so far above what it needs to be that it is no longer practical for reserve reduction to be the driver of a higher Fed Funds Rate. Instead, when the Fed makes its first rate hike — something that probably won’t happen until at least September-2015 — it will do so by 1) raising the interest rate paid on bank reserves, 2) increasing the amount that it pays to borrow money via Reverse Repurchase agreements, and 3) boosting the rate that it offers to financial institutions for term deposits.

A recent Mineweb article warrants a brief discussion. The article contains several illogical statements, which is not surprising considering the author. For example, this is from the second paragraph: “…the fact remains that any entity with sufficient capital behind it can usually move any market in the direction that suits it…” Large financial institutions and hedge funds undoubtedly wish that this were true, but in the real world these entities ‘come a cropper’ when they take big positions that aren’t fundamentally justified. However, I’ll ignore the other flaws and zoom in on the Ted Butler assertion that constitutes the core of the article. I’m referring to the assertion that banking behemoth JP Morgan (JPM) has managed to accumulate a 350M-oz hoard of physical silver while simultaneously causing the silver price to trend downward via the selling of futures contracts. It’s analysis like this that gives gold and silver bulls a bad name, because anyone with knowledge of how markets work will immediately see that it is complete nonsense.

Selling commodity futures and simultaneously buying the physical commodity cannot cause a downward trend in the commodity price, assuming that the amount sold via the futures market is equivalent to the amount bought in the spot market. Price-wise, the only effect would be to boost the spot price of the commodity relative to the price for delivery at some future time. Selling more via the futures market than is bought in the spot market could temporarily push the price downward, but the operative word here is “temporarily” since every short-sale must subsequently be closed out with a purchase. In any case, I get the impression from the above-linked article that JPM has supposedly managed to bring about a downward trend in the silver price while remaining net ‘flat’. This is not possible.

I don’t know how much physical silver is owned by JPM or what JPM’s net exposure to silver is*, and I couldn’t care less. I certainly see no good reason to comb through documents trying to find the answer because the answer is totally irrelevant to the investment case for silver. The investment case for silver is determined partly by silver’s market value relative to the market values of gold and the industrial metals, and partly by the same macro-economic fundamentals that are important for gold. Right now, silver has reasonable relative value and neutral fundamentals, with the fundamentals looking set to improve during the second half of this year.

I’m ‘long’ physical silver, despite, not because of, the ‘analyses’ of some of the most outspoken silver bulls.

*Neither does Ted Butler nor anyone else who isn’t a senior manager at JPM

At the beginning of last week I wrote that gold and the HUI were coiling, the implication being that a sharp 1-3 week move in one direction or the other would soon begin. There was no way of knowing the direction of the move, although the performance of the HUI/gold ratio relative to its 40-day moving average (MA) suggested that the direction would be up.

There were multiple head fakes last week, with a) gold bullion almost breaking out to the downside last Friday, b) the HUI chopping around near its 50-day MA, and c) the HUI/gold ratio being the only consistent indicator by sustaining its upside breakout. At this stage it looks like the HUI/gold ratio was sending the correct message, because both gold bullion and the HUI closed above the tops of their recent trading ranges on Tuesday 28th April.

The minor upside breakouts in gold-related stuff happened on the day before the Fed is scheduled to issue its next policy statement, which is out of character considering how gold has traded over the past 9 months. As noted in a commentary posted at TSI a few days ago, gold had closed lower over the course of the 5 trading days leading up to each of the past 6 FOMC meetings and would have stretched the negative pre-FOMC sequence to 7 if it had closed below $1201.80 on 28th April. Instead, it rebounded strongly and closed at $1211.50.

My thinking was that if the gold price had fallen over the first 2 trading days of this week it would have set the stage for a significant post-FOMC rebound, because the most likely outcome of this week’s FOMC meeting is a statement with almost no wording changes. No meaningful change to the wording of the Fed’s statement would mean that a June rate hike had effectively been taken off the table, which short-term speculators would undoubtedly view as gold-bullish (it’s actually irrelevant, but short-term moves are being driven by sentiment).

However, it seems that speculators have jumped the gun. As a result, buying in advance of Wednesday’s FOMC statement is now riskier. My guess is that gold and the gold-mining stocks will extend their gains if the Fed signals “no rate hike in June”, but there is now more downside risk associated with an unexpectedly ‘hawkish’ Fed statement.

One of the criticisms of the current monetary system is that the money isn’t backed by anything. However, while there are some big problems with the current system, this criticism isn’t valid. The reason is that money is never backed by anything.

Taking the specific case of the US dollar, the view that the US$ should be backed by something and the related view that the absence of backing implies a major flaw is a hangover from the Gold Standard. Under the Gold Standard that existed in the US prior to the early-1930s, a US dollar represented and was exchangeable into a fixed amount of gold.

The critical point is that under the Gold Standard the US$ wasn’t money; gold was money. The US dollars in circulation were receipts or IOUs that entitled the bearer to a certain amount of gold (money). The dollar itself wasn’t money. At most, it was a “money substitute”.

Today’s paper dollars are not IOUs or receipts. They are not “money substitutes”, they are money proper. Consequently, they do not need to be backed by anything. In fact, if they were backed by something then whatever was doing the backing would be money and the dollar itself would be a money substitute rather than actual money.

The situation isn’t as clear with regard to dollars in bank deposits as it is with regard to paper dollars, as the dollars in bank deposits are backed by the promise of the banking system to convert from electronic to paper on demand. It could therefore be argued that electronic dollars in bank deposits are money substitutes rather than money, although it is reasonable to count them in the money supply because the central bank has the ability to meet any demand for the conversion of electronic dollars into paper dollars.

The fact that today’s money isn’t backed by anything is therefore not the problem. If gold were money then the money also wouldn’t be backed by anything. That’s the nature of money. The problem, instead, is that for something to be GOOD money its supply should be fairly stable and it should be widely perceived to have value outside its role as a medium of exchange. The US dollar and all of today’s official monies fail to meet either of these requirements, whereas cryptocurrencies such as Bitcoin fail to meet the second requirement.

A hedging program can make sense for a gold producer, but hedging is something that — with a small number of exceptions — gold producers should never do. This is not because there will always be a direct cost or an opportunity cost associated with any hedging program, it’s because gold producers are so damn bad at it.

In order to optimise cash flow and make short-term financial performance more predictable, it will generally make sense for a gold producer to forward-sell some of its future production, either via a bullion bank or the futures market, after a run-up in the gold price to near a 6-month high. Provided that the total amount forward sold never exceeds more than half of the next 12 months of production, this type of hedging program would always smooth cash flows and would often increase cash flows. It would create an opportunity cost in a very strong gold market, but the cost would not be substantial because all production beyond the coming 12 months would remain unhedged.

However, gold-mining executives have proved over and over again that when it comes to the timing of their hedging moves, they are the proverbial dumb money. They get scared and put hedges in place following a large price decline and then get pressured into removing the hedges at great cost following a large price rise.

In other words, rather than locking-in relatively high prices for a portion of future production by hedging when the market is ‘overbought’, if they hedge at all it is usually when the market is ‘oversold’. Consequently, their hedges tend to lock-in relatively low prices for a portion of future production.

And it’s not just the hedging of future sales that gold-mining executives routinely make a mess of. They are usually just as bad when it comes to hedging their costs. For one example, Barrick Gold chose to mitigate the risk of future gains in the oil price by purchasing some oil production, the idea being that what its gold-mining business lost due to a higher oil price would be partially offset by increased profits from the oil business. The problem is that it made the purchase in mid-2008 — right at the secular peak for the oil price. For another example, the senior management of Gold Fields (GFI) implemented a hedging program covering the bulk of the company’s oil exposure through to the end of 2015. The problem is that the program was put into place just prior to last year’s oil price crash and therefore prevents GFI shareholders from obtaining any benefit from the lower oil price this year.

When trading or investing it is of vital importance to acknowledge your own weaknesses. For example, there is no shame in being a poor short-term trader provided that in recognition of this reality you risk very little money on short-term trades. Gold mining executives should acknowledge that they are hopeless at hedging and should stop trying to do it.

I have never been in the camp that exclaims “buy gold because the US is headed for hyperinflation!”. Instead, at every step along the way since the inauguration of the TSI web site in 2000 my view has been that the probability of the US experiencing hyperinflation within the next 2 years — on matters such as this there is no point trying to look ahead more than 2 years — is close to zero. That is still my view. In other words, I think that the US has a roughly 0% probability of experiencing hyperinflation within the next 2 years. Furthermore, at no time over the past 15 years have I suggested being ‘long’ gold due to the prospect of a rapid rise in the CPI. This is partly because at no time during this period, including the present, has a rapid rise in the CPI seemed like a high-probability intermediate-term outcome, but it is mainly because gold has never been and is never likely to be a play on “CPI inflation”.

Gold is a play on the economic weakness caused by bad policy and on declining confidence in the banking establishment (led by the Fed in the US). That’s why cyclical gold bull markets are invariably born of banking/financial crisis and/or recession, and why a cyclical gold bull market is more likely to begin amidst rising deflation fear than rising inflation fear.

There are times when the declining economic/monetary confidence that boosts the investment demand for gold is linked to expectations of a rapid increase in “price inflation”, but it certainly doesn’t have to be. For example, the entire run-up in the gold price from its 2001 bottom to its 2011 peak had nothing to do with the CPI. Also, an increase in the rate of “CPI inflation” would only ever be bullish for gold to the extent that it brought about declining confidence in the economy or the banking establishment, as indicated by credit spreads, real interest rates, the BKX/SPX ratio and the yield curve. Since it’s possible for the CPI to accelerate upward without a significant decline in confidence, it’s possible that an upward acceleration in the CPI would not be bullish for gold.

The bottom line is that as far as the gold market is concerned, the CPI is more of a distraction than a driver.