[This blog post is an excerpt from a commentary published at TSI on 1st September 2019.]

It’s well known that the US$ gold price often trends in the opposite direction to the US real interest rate. This relationship is illustrated by the following chart in which the real interest rate is represented by the yield on the 10-year TIPS (Treasury Inflation Protected Security).

Notice that the 10-year TIPS yield has just gone negative and that the previous two times that this proxy for the real interest rate went negative the gold price was at an important peak. Specifically, the real interest rate going negative in August-2011 coincided with a long-term top in the gold price and the real interest rate going negative in July-2016 coincided with an intermediate-term top in the gold price. If gold tends to benefit from a lower real interest rate, why would the gold price reverse downward shortly after the real interest rate turned negative?

Considering only the 2016 case the answer to the above question seems obvious, because in July-2016 the TIPS yield reversed course and began trending upward soon after it dipped into negative territory. In other words, the downward reversal in the gold price coincided with an upward reversal in the real interest rate. However, in 2011-2012 the real interest rate continued to trend downward for more than a year after the gold price peaked.

We think there are two reasons why the gold price didn’t make additional gains in 2011-2012 after the real interest rate turned negative. First and foremost, the real interest rate is just one of several fundamental gold-price drivers (the 10-year TIPS yield is one of seven inputs to our Gold True Fundamentals Model), and after August-2011 the upward pressure exerted by a falling real interest rate was counteracted by the downward pressure exerted by other fundamental influences. Second, in August-2011 a further significant decline in the real interest rate had been factored into the current gold price.

The risk at the moment is that on a short-term basis the bullish fundamental backdrop, including the potential for a further decline in the ‘real interest rate’, is fully discounted by the current price. This risk is highlighted by the fact that the total speculative net-long position in Comex gold futures is very close to an all-time high. It is also highlighted by the fact that the RSI displayed in the bottom section of the following weekly chart is almost as high as it ever gets.

The relationship between short-term market interest rates and the interest rates set by the Fed is a complicated one. The market makes predictions about what the Fed is going to do and moves in anticipation, but at the same time the Fed’s interest-rate settings are influenced by what’s happening to market interest rates. Also, market interest rates are determined by factors other than what the Fed is doing or expected to do to its official rate targets, and as a result there are times when the market and the Fed seem to be at odds with each other.

At the moment there is no doubt that the market is leading the Fed. In particular, the Fed has been swayed towards rate cutting partly by the fact that the market has discounted rate cuts. This can be established by comparing recent movements in market interest rates with changes in the Fed’s interest rate targets, which I’ll get to shortly. It can also be established by referring to the Fed’s own statements. For example, the minutes of the July FOMC meeting included the following assessment:

“Participants observed that current financial conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy to help offset the drag on economic growth stemming from the weaker global outlook and uncertainties associated with international trade as well as to provide some insurance to address various downside risks.”

In essence, the Fed has admitted here to being worried that if it doesn’t cut rates like the market expects then financial conditions could get a lot worse. The implication is that if the market expects the Fed to cut rates, then to avoid disappointing the market (and risking the deterioration of financial conditions) the Fed will cut rates.

I mentioned above that the market’s current leadership can be established by comparing recent movements in market interest rates with changes in the Fed’s interest rate targets. Displayed below is a chart that makes this case. The chart shows the performance of the 2-year Treasury yield and indicates the last two interest-rate changes made by the Fed. Notice that:

1) The 2-year market interest rate began trending downward in early-November of 2018.

2) The Fed made its last rate hike during the second half of December 2018, that is, the Fed was still in rate-hiking mode six weeks after a short-term market interest rate began trending downward.

3) The Fed made its first rate cut at the end of July 2019. By that time, the 2-year market interest rate had been trending downward for almost 9 months.

It’s reasonable to assume that additional Fed rate cuts are on the way. Bear in mind, however, that a few additional rate cuts have already been factored into market prices, so market prices won’t necessarily respond in the obvious way to future Fed rate cuts. Also bear in mind that market interest rates probably will begin trending upward while the Fed and other central banks are still in rate-cutting mode.

[This post is a modified excerpt from a recent TSI commentary]

Gold tends to lead the industrial metals sector at intermediate-term bottoms, that is, the US$ gold price tends to make an intermediate-term bottom and commence a multi-quarter (or multi-year) upward trend in advance of the Industrial Metals Index (GYX). Evidence of this can be found on the following chart comparison of the US$ gold price and GYX. Specific examples are:

a) The gold price reversed upward in April of 2001 and GYX did the same in November of that year.

b) The gold price reversed upward in October-November of 2008 and GYX did the same in February-March of 2009.

c) The gold price reversed upward in December of 2015 and GYX followed suit in January of 2016.

Gold’s most recent intermediate-term bottom was in August of 2018. It has since trended upward and over the past two months the trend accelerated. GYX, however, continued to make lower lows until June of 2019. It’s too early to tell if GYX’s June-2019 low was the intermediate-term variety, but regardless of whether or not it makes a new low within the next couple of months the performance of the gold market suggests that the industrial metals sector will commence an intermediate-term rally before the end of this year.

The Baltic Dry Index (BDI) is also predicting an industrial metals rally

The BDI is an index of dry bulk shipping rates. I generally don’t use it as an economic or a financial-market indicator, because it is influenced as much by changes in the supply of shipping capacity as by changes in the global demand for commodities. However, intermediate-term trends in the BDI often match intermediate-term trends in the Industrial Metals Index (GYX). Also, large short-term divergences between the BDI and GYX tend to be important, with one or the other subsequently making a big catch-up move in quick time.

As illustrated by the following chart, a large divergence has opened up over the past four months due to the BDI rocketing up to a 5-year high while GYX languishes near a 2-year low. This divergence could be closed by either a dramatic plunge in the BDI or a substantial rally in the industrial metals sector. I suspect it will be the latter.

The euro may well gain in value relative to the US$ over the next 12 months, but three differences between the monetary systems of the US and the euro-zone guarantee that the euro will collapse (cease being a useful medium of exchange) before the US$ collapses.

The first difference is to do with the euro-zone system being an attempt to impose common monetary policy across economically and politically disparate countries. This is a problem. A central planning agency imposing monetary policy within a single country is bad enough because it generates false price signals and in so doing reduces the rate of economic progress. However, when monetary policy (the combination of interest-rate and money-supply manipulations) is implemented across several economically-diverse countries the resulting imbalances grow and become troublesome more quickly.

As an aside, money is supposed to be a medium of exchange and a yardstick, not a tool for economic manipulation. Therefore, it is inherently no more problematic for different countries to use a common currency than it is for different countries to use common measures of length or weight. On the contrary, a common currency makes international trading and investing more efficient. For example, there were long periods in the past when gold was used simultaneously and successfully as money by many different countries. However, if a currency can be created out of nothing then there is no getting around the requirement to have an institution that oversees/manages it. The euro therefore could not be ‘fixed’ by simply eliminating the ECB. The ECB and the one-size-fits-all monetary policy it imposes are indispensable parts of the euro-zone system.

The second difference is linked to the concept that a government with a captive central bank cannot become insolvent with respect to obligations in its own currency. For example, due to the existence of the Fed the US government will always have access to as much money as it needs to meet its obligations, regardless of how much debt it racks up. Putting it another way, should all other demand for Treasury debt disappear the Fed will still be there to monetise whatever amount of debt the US government issues. Consequently, the US government will never be forced to directly default on its debt.

It’s a different story in the euro-zone, however, because the ECB is not beholden to any one government. The provision of ECB financial support to one euro-zone government therefore requires the acquiescence of other governments. This hasn’t been a stumbling block to date and the ECB has provided whatever support was needed to prevent financially-stressed euro-zone governments from directly defaulting on their debts, but eventually a point will be reached when the governments of some countries balk at their interest rates and money being distorted as part of an effort to prop-up the finances of other governments. At that point there will be direct default on euro-zone government debt or the disintegration of the monetary union.

Once it becomes clear that direct default on government debt is a risk to be reckoned with, ‘capital’ will flee the euro-zone at a rapid rate. This is because the main (only?) reason to own government bonds is that they are supposedly risk free.

The third critical difference between the US and euro-zone monetary systems is similar to the second difference. In the US there is a symbiotic relationship between the Fed and the government, with one institution always prepared to support the other in a time of crisis. One consequence of this relationship is the impossibility — as discussed above — of the US government ever being forced to directly default on its debt. Another consequence is the impossibility of the Fed ever becoming bankrupt.

Several years ago there was much speculation that the Fed would go broke due to large losses on the bonds it was buying in its QE operations, but this speculation was never well-informed. Up until now the Fed has made out like the bandit it is on its ‘investments’ in Treasury and mortgage-backed securities, but even if these securities had collapsed in value it would not have resulted in the Fed going bust. It simply would have led to a line being added to the Fed’s balance sheet to keep the books in balance.

Again, though, it’s a different story in the euro-zone. Should the ECB begin to incur large losses on its bond portfolio there is no certainty that it would be able to keep going about its business as usual. To do so would require the support of governments/countries that never benefited from and never whole-heartedly agreed with the programs that led to the pile-up of low-quality bonds on the ECB’s balance sheet.

Summing up, the US monetary system is problematic in that it gets in the way of economic progress, but it is much less fragile than the euro-zone monetary system. That’s why the euro-zone system will be the first to collapse.

Below is an excerpt from a recent TSI commentary.

An investment’s true fundamentals exert pressure on its price. It is not unusual for the price to trend in the opposite direction to the fundamentals for a while, but if fundamentals-related pressure consistently acts in one direction then the price should eventually fall into line by trending in that direction. Our “true fundamentals” models for gold, the US stock market, the Dollar Index and commodities (the GSCI Commodity Index) are attempts to quantify the magnitude and direction of fundamentals-related pressure.

We have a lot of confidence in our Gold True Fundamentals Model (GTFM), because we understand why it should work and we know that it has worked well over a long enough period to rule out luck/randomness. It isn’t a short-term timing indicator, but all intermediate-term trends in the US$ gold price over the past 17 years* have been in line with the fundamentals as reflected by the GTFM. However, we have less confidence in our other true fundamentals models.

We recently have given more thought to the construction of our Equity True Fundamentals Model (ETFM), which is designed to indicate the direction and magnitude of fundamentals-related pressure on the US stock market (as represented by the S&P500 Index).

The version of the ETFM that we have been using takes into account credit spreads, the yield curve, the real interest rate (as indicated by the 10-year TIPS yield), the relative strength of the banking sector and the G2 monetary inflation rate, with the monetary inflation rate given a greater weighting than the other inputs. However, we now think it was a mistake to put extra emphasis on monetary inflation. This is because although the rate of change in the money supply is the most important long-term driver of the stock market, the time between a trend change in monetary inflation and the effects of this trend change becoming evident in the stock market is long and variable.

In an effort to make the ETFM more useful over the intermediate-term (6-18 month) periods that are of primary interest to us we have made two changes to the Model’s construction. First, we have reduced the emphasis on monetary inflation so that it has the same weighting as the Model’s other inputs. Second, the ISM New Orders Index (NOI) has been added as an input to the Model. This input will be set to 1 when the NOI is 55 or above and set to 0 when the NOI is below 55. This is being done because a) the stock market tends to perform much better when the NOI is greater than 55 than when the NOI is less than 55, and b) there is a strong tendency for the NOI to fall below 55 PRIOR to periods of significant stock market weakness, meaning that weakness in the NOI is not simply a reaction to weakness in the stock market.

The above changes didn’t make a big difference to the historical performance of the ETFM, but they did make the Model a little more sensitive to shifts in the fundamental winds. This is a plus, because the original model wasn’t sensitive enough. Note, as well, that these changes did not alter the current signal. Both the original ETFM and the new/improved ETFM switched from neutral to bearish on 19th April 2019.

Here is a chart comparing the new ETFM (the blue line) with the SPX since the start of 2002. Stock market fundamentals are considered to be bearish when the ETFM is below 50, neutral when the ETFM equals 50 and bullish when the ETFM is above 50.

The true fundamentals are equity-bearish at the moment. If they remain bearish then the price eventually WILL fall into line. Furthermore, the longer the price trends upward or stays elevated in parallel with a bearish fundamental backdrop, the faster the eventual downward price move is likely to be.

*For some of the GTFM inputs we don’t have data prior to the early-2000s, so we can’t compare the GTFM and the gold price during earlier periods.

There is no simple relationship between interest rates and the stock market. In particular, a lower interest rate doesn’t necessarily lead to a higher stock market and a higher interest rate doesn’t necessarily lead to a lower stock market.

The conventional wisdom on this topic is based largely on what happened over the past few decades. Clearly, US equities generally fared well after interest rates embarked on a long-term downward trend in the early 1980s and generally fared poorly when interest rates were in a rising trend during the 10-14 year period prior to the early 1980s. Also, the inverse relationship (a lower interest rate leads to a higher stock market and a higher interest rate leads to a lower stock market) seemed to make sense and was incorporated into a popular stock market valuation tool called “The Fed Model”.

The Fed Model compares the earnings yield of the S&P500 Index (the reciprocal of the S&P500′s P/E ratio, expressed as a percentage) with the 10-year T-Note yield to determine if the stock market is over-valued or under-valued. The higher the S&P500 yield relative to the 10-year T-Note yield, the better the value supposedly offered by the stock market. An implication is that if the 10-year yield is very low, the S&P500 can have a very high P/E ratio and still not be over-valued. For example, according to the Fed Model the S&P500 is attractively valued today. This is because even though the current P/E ratio is almost as high as it ever gets (excluding the 1999-2000 bubble period), the current earnings yield is well above the current 10-year T-Note yield.

However, the simple relationship between interest rates and the stock market only makes sense at a superficial level. It doesn’t hold up under deeper analysis. The reason is that the current value of a company is the sum of all of that company’s future cash flows discounted at some rate, and in most cases it will not be appropriate to use today’s interest rate to discount cash flows that won’t happen until many years or even decades into the future.

When picking a rate at which to discount distant cash flows it would be more reasonable to use a long-term average interest rate than to use the current interest rate. Furthermore, there is no good reason why the change in the interest rate over the next 12 months should significantly affect the interest rate used to discount cash flows that are expected to occur 10-20 years into the future.

But if it is wrong to assume that the stock market should trend inversely to the interest rate over long periods, then why did this assumption prove to be correct over the bulk of the past 50 years?

The first part of the answer is that over the very long term the stock market swings from under-valued to over-valued and back again and that in the early 1980s a bond market under-valuation extreme happened to coincide with a stock market under-valuation extreme. The second part of the answer is that financial market history goes back much further than 50 years and the simple relationship on which the Fed Model is based is not apparent prior to 1970. In essence, the theory that a lower interest rate leads to a higher stock market and a higher interest rate leads to a lower stock market is an artifact of the past 50 years.

The above statement is supported by the following charts. The charts show the Dow Industrials Index and the 10-year T-Note yield from the beginning of 1925 through to the end of 1968.

The US stock market (as represented by the Dow Industrials in this case) was in a secular bearish trend from 1929 until 1942. Apart from an upward spike due to fear of government default in 1931, the 10-year yield was in a downward trend during this bearish stock market period. The stock market then embarked on a secular bullish trend that didn’t end until the late-1960s. The 10-year yield was in an upward trend during this bullish stock market period. That is, the long-term relationship between interest rates and the stock market during 1929-1968 was the opposite of what it was over the past 50 years.

A large divergence between two fundamentally-correlated market prices is important because such a divergence usually will be closed via a big move in one or both prices. However, divergences sometimes build for an inconveniently long time before they start to matter.

The gold/commodity ratio (the US$ gold price divided by the GSCI Spot Commodity Index) and the T-Bond are strongly correlated over the long term. They also tend to be well correlated over shorter timeframes, but significant short-term divergences sometimes occur. One such divergence has been developing since the beginning of this year, with the T-Bond making a sequence of higher highs while the gold/commodity ratio stays below its late-December high. Note that even the recent surge to a new 5-year high by the US$ gold price was not enough to push the gold/GNX ratio above its late-December high.

The current divergence and previous similar divergences (higher highs for the T-Bond in parallel with lower highs for the gold/commodity ratio) are illustrated by the following chart. The previous similar divergences led to large declines in the T-Bond price and I can think of no reason to expect that it will be different this time.

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

Gold tends to perform well relative to commodities in general when inflation expectations are FALLING. The evidence is presented below in chart form.

The first of the following charts shows the Expected CPI, which in this case is determined by subtracting the yield on the 5-year TIPS (Treasury Inflation Protected Security) from the yield on the 5-year T-Note. In effect, the chart shows the average annual “inflation” rate that the market expects the US government to report over the next 5 years. We’ve labeled all of the important highs and lows on this chart.

The second of the following charts shows the gold/commodity ratio (the US$ gold price divided by the GSCI Spot Commodity Index). The labels on this chart correspond to the labels on the first chart. For example, point A on the first chart is the same time as point A on the second chart.

Notice that in every case over the 6-year period covered by the following charts, a high for inflation expectations (the Expected CPI) is associated with a low for the gold/commodity ratio and a low for inflation expectations is associated with a high for the gold/commodity ratio.

The relationship we tried to show above is more clearly demonstrated by the next chart. On this chart the commodity/gold ratio (as opposed to the gold/commodity ratio) is compared to the ProShares Inflation Expectations ETF (RINF). The correlation clearly is strong, with commodities consistently outperforming gold when inflation expectations are rising and underperforming gold when inflation expectations are falling.

An implication of the above charts is that if inflation expectations are close to an intermediate-term bottom then the financial world is close to the start of a 6-12 month period during which the industrial metals perform better than gold. Alternatively, a further decline in inflation expectations (increasing fear of deflation) would lead to additional relative strength in gold.

We realise that the above message is the opposite of what most people believe about gold, but a lot of what most people believe about gold is not accurate. Of particular relevance to this discussion, gold has never been a hedge against “price inflation”.

Gold tends to perform relatively well during periods when financial-system and/or economic confidence is on the decline. The declining confidence sometimes will go hand-in-hand with rapid “price inflation”, but it isn’t reasonable to expect gold to be a useful hedge against what generally is considered these days to be normal “inflation”. In fact, part of the reason for the strong INVERSE relationship between the gold/commodity ratio and inflation expectations is the general view that “inflation” of 2%-3% is beneficial.

Our view is that the next three months could be dicey, especially if there’s another sharp decline in the stock market. However, we think that by the end of this year inflation expectations will be significantly higher and industrial metals such as copper and platinum will be significantly more expensive relative to gold.

[This post is a slightly-modified excerpt from a TSI commentary published about two weeks ago.]

The way that most new money was created over the past 10 years was different to how it was created during earlier cycles. During earlier cycles almost all new money was loaned into existence by commercial banks, but in the final few months of 2008 the Fed stopped relying on the commercial banks and began its own money-creation program (QE).

The difference is important because most of the money created by commercial banks is injected into the ‘real economy’ (the first receivers of the new money are businesses and the general public), whereas all of the money created by the Fed is injected into the financial markets (the first receivers of the new money are bond traders). The Fed’s new money eventually will find its way to Main Street (as opposed to Wall Street), but the rate of monetary inflation experienced by the ‘real economy’ during the years following the Global Financial Crisis was a lot lower than suggested by the change in the US True Money Supply (TMS). Consequently, there may have been a lot less mal-investment during the current cycle than during the years leading up to the 2007-2009 crisis.

Don’t get us wrong — there has been a huge amount of ill-conceived and misdirected investment due to the Fed’s money-pumping and associated suppression of interest rates. Due to these bad investments, corporate balance sheets are now much weaker, on average, than otherwise would be the case. In particular, the corporate world collectively has gone heavily into debt and in a lot of cases the debt has not been used productively. For example, it has been used to buy back shares or fund high-priced acquisitions. This will have very negative consequences for the stock market within the next few years, but wasting money on share buy-backs and over-paying for assets does not cause the business cycle.

The ‘boom’ phase of the business cycle happens when artificially-low interest rates prompt investment, on an economy-wide scale, in new production facilities and construction projects that would not have seemed viable in the absence of the distorted interest-rate signal. The ‘bust’ phase of the business cycle kicks off when it starts to become apparent that, due to rising construction/production costs and/or less consumer demand than forecast, the aforementioned investments either cannot be completed or will generate a lot less cash than originally expected. Widespread liquidation ensues, and — as long as policy-makers don’t do too much to ‘help’ — resources eventually get reallocated in a way that meshes with sustainable consumer demand. The economy recovers.

The above is background information for the following charts. The first chart shows the year-over-year (YOY) rate of change in US True Money Supply (TMS), a.k.a. the US monetary inflation rate. The second chart shows the US monetary inflation rate without the Fed’s direct additions and deletions*.

Note that the second chart does not show what would have happened to the US monetary inflation rate in the absence of the Fed. Regardless of whether the Fed is creating new money or not, it exerts a strong influence on the commercial banks. What we have tried to do with the second chart is isolate the monetary inflation that causes the business cycle.

Prior to late-2008 the charts are very similar, but from late-2008 onwards there are some big divergences. The most obvious divergence was in 2009, when the rate of growth in TMS extended the rapid upward trend that began in 2008 while the rate of growth in “TMS minus Fed” collapsed to well below zero. Also worth mentioning is that the rate of growth in “TMS minus Fed” was in negative territory from August-2013 to June-2014, a period during which the rate of growth in TMS never dropped below 7%.

The swings in the “TMS minus Fed” growth rate explain some of the important swings in the US economy. For example, the rapid increase in “TMS minus Fed” during 2011-2012 almost certainly is linked to the mad rush to invest in the shale oil industry, and the 2013-2014 plunge in “TMS minus Fed” would be partly responsible for the collapse of the shale-oil investment boom during 2014-2015. Although it was focused on a single industry, this was a classic case of the mal-investment that results in a boom-bust cycle.

Over the past 18 months the TMS growth rate has extended its major downward trend, but the “TMS minus Fed” growth rate has rebounded. This rebound could delay the start of a recession.

*We assume that the amount of money added by the Fed equals the increase in the Fed’s holdings of securities minus the increase in Reverse Purchase Agreements.

After spending almost all of 2018 in bearish territory, gold’s true fundamentals* (as indicated by my Gold True Fundamentals Model – GTFM) have spent all of this year to date in bullish territory. Refer to the following chart comparison of the GTFM (the blue line) and the US$ gold price (the red line) for the details.

A market’s true fundamentals are akin to pressure. Due to sentiment and other influences a market can move counter to the fundamentals for a while, but if the fundamentals continue to act in a certain direction then the pressure will build up until the price eventually falls into line. Also, even if it isn’t sufficient to bring about a significant rally, the upward pressure stemming from a bullish fundamental backdrop will tend to create a price floor. That’s what happened with gold during March and April.

As was the case when I last addressed this topic at the TSI Blog, the most important GTFM input that is yet to turn bullish is the yield curve (as indicated by the 10year-2year and 10year-3month yield spreads). This input shifting from bearish to bullish requires a reversal in the yield curve from flattening (long-term rates falling relative to short-term rates) to steepening (long-term rates rising relative to short-term rates). If the reversal is driven primarily by falling short-term interest rates it indicates a boom-to-bust transition, such as occurred in 2000 and 2007, whereas if the reversal is driven primarily by rising long-term interest rates it points to increasing inflation expectations.

As illustrated below, at the end of last week there was no evidence of such a trend change in the 10year-3month yield spread.

To get a gold bull market there probably will have to be a sustained trend reversal in the yield curve. I think that will happen during the second half of this year, but it hasn’t happened yet. Also, when it does happen my guess is that it will be driven by rising long-term interest rates (indicating rising inflation expectations), not falling short-term interest rates. That’s an out-of-consensus view right now, because inflation expectations are low/falling and almost everyone has come to the conclusion that an aggressive Fed rate-cutting campaign will get underway in the near future.

Another GTFM input that could shift from bearish to bullish in the near future and thus add to the upward pressure on the gold price is the currency exchange rate input. At the moment, all it would take to bring about this shift is a weekly close in the Dollar Index about half a point below last week’s close.

My guess is that there will be some corrective activity in the gold market over the coming 1-2 weeks, but as long as the GTFM stays in bullish territory the fundamentals-related upward pressure should enable the gold price to make new multi-year highs within the next few months.

*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.

In 1961, Deng Xiao Ping uttered what is perhaps his most famous quotation: “I don’t care if it’s a white cat or a black cat. It’s a good cat so long as it catches mice.” This was interpreted to mean that being economically successful is more important than being loyal to any particular ideology.

Deng’s view that having a productive economy was more important than adhering rigidly to theories that were failing in practice brought him into conflict with Mao Tse Tung. It could be argued that Deng was more practical than Mao in that he was prepared to allow/encourage some elements of a market economy, although if the primary objective is holding onto political power then what’s practical is not necessarily what’s best for the country.

From a purely political perspective, Mao was practical. His policies generally had disastrous economic effects, but in addition to maintaining power he was able to stay popular with China’s peasant class (his political support base). He did this by creating the impression that there was always a revolution — of one form or another — to be fought. There were always enemies that had to be defeated, mountains that had to be climbed and sacrifices that had to be made in the present in order to set the stage for a brighter future.

The revolutionary feeling was sustained via a series of dramatic programs and policy shifts, chief among them being:

1. “The Hundred Flowers Campaign” of 1956-1957: Mao encouraged differing opinions on how China should be governed and even permitted public criticism of the Communist Party leadership.

2. “The Anti-Rightist Movement” of 1957-1959: Those who accepted Mao’s invitation to express anti-communist opinions under the “Hundred Flowers Campaign” were eliminated (purged, imprisoned, killed). Quite likely, the “Hundred Flowers Campaign” was just a ruse to identify anyone who could possibly be a threat to Mao.

3. “The Great Leap Forward” of 1958-1962: A 5-year plan focusing on the collectivisation of agriculture that caused widespread food shortages and resulted in the death of tens of millions of people (estimates of the famine-related death toll range from 20M to 45M). This disaster created the first serious rift between Mao and Deng, which eventually led to Deng being purged from the Communist party in the early days of the “Cultural Revolution”.

4. “The Cultural Revolution” of 1966 through to Mao’s death in 1976: Ostensibly a movement to topple the “ruling class”, spread power more evenly and stamp out counter-revolutionary activities, this was Mao’s most blatant attempt to keep China in a perpetual state of revolution. During the “Cultural Revolution”, anyone considered to have skills above those of the average person became a likely target for persecution. In addition, formal education all but ceased, countless works of art and historical buildings were destroyed, and Mao’s “Little Red Book” of quotations effectively became the bible. The result was social and economic chaos.

Fortunately for China, Deng was able to gain control of the Communist Party following Mao’s death. The reforms he implemented showed that even a modicum of economic freedom can go a long way towards improving living standards.

Interestingly, one of the most successful reforms of the Deng era was not the brainchild of Deng, but was, instead, developed by local farmers who were desperate to escape the poverty that collectivised agriculture had imposed upon them. In much the same way that America’s Pilgrims adopted private ownership of farmland in response to a communal system’s failure to produce sufficient food, the inhabitants of one small Chinese village decided, in 1978, to experiment with a new system under which individuals and families would have ownership of farmland. The experiment was a huge success, and was subsequently tried — also with great success — in some other villages. After learning of these experiments and the resultant large increases in agricultural productivity, Deng openly praised the participants and encouraged the nationwide adoption of the ‘new’ system. It is almost certain that the government’s reaction would have been very different if Mao had still been in power.

China’s political leaders between Deng Xiao Ping and Xi Jin Ping, the current leader, were really just place fillers. It’s clear that Xi is the most important leader of the Communist Party of China (CPC) since Deng.

Xi seems to be more like Mao than Deng, in that he places the supremacy of the Party above all other considerations and puts a strong emphasis on Communist ideology. He has made this clear in numerous speeches. For example:

At the October 2017 19th Party Congress, he said: “Government, military, society and schools, north, south, east and west, the Party is the leader of everything.”

And in March-2018, Xinhua (China’s official state-run press agency) quoted him as saying: “The Party exercises overall leadership over all areas of endeavor in every part of the country. A primary task of deepening reform of the Party and state institutions is to strengthen the CPC’s leadership in every sector.”

The phrase “capitalism with Chinese characteristics” is not used in China, at least not by any high-ranking members of the CPC. Only Western pundits believe that China is shifting towards capitalism. In China the political system is often referred to as “socialism with Chinese characteristics”. Here are two examples from a Xi speech given last year at the Central Commission for Discipline Inspection (CCDI) Plenary Session:

“[Party members should] understand the dialectical relationship between the grand vision of Communism and socialism with Chinese characteristics.”

“We cannot indulge ourselves in empty talk without working for the cause of socialism with Chinese characteristics and national rejuvenation. We can neither afford to lose the grand vision because realizing Communism is a long process.”

And here’s an excerpt from a Xinhua article that quotes Xi making the same point:

“The purpose of reviewing the Communist Manifesto is to understand and grasp the power of the truth of Marxism and write a new chapter of socialism with Chinese characteristics in the new era, Xi said. It’s necessary to “apply the scientific principles and the spirit of The Communist Manifesto to the overall planning of activities related to the great struggle, great project, great cause, and great dream,” he said. More efforts should be made to develop Marxism in the 21st century and in contemporary China, and write a new chapter of adapting Marxism to the Chinese context, Xi said.”

Like Mao, Xi is attempting to galvanise support behind himself and the Party (Xi is now defined as the “core” of the Party) by promoting the idea that China and the Chinese people are under threat. In this regard he is being helped by having a ready-made enemy in the form of a US government that clearly is trying to contain China both economically and militarily. Moreover, the “trade war” and the US government restrictions on US corporations doing business with Huawei make Xi look prescient, because he has warned for many years that this sort of thing could happen and therefore that it was dangerous for Chinese manufacturers to rely on imported technology.

Unfortunately for Xi, innovation, which he correctly perceives to be lacking in China, won’t happen at the command of government.

Also like Mao, Xi does not tolerate any dissension. All views must be consistent with the goal of having a population unified in its beliefs in “socialism with Chinese characteristics” and the primacy of the Party in all aspects of life. Hence the draconian treatment of millions of Muslims in Xinjiang Province, the severe policing of opinions expressed in social media and the setting-up of the world’s largest domestic surveillance network.

In a way, China has come full circle. However, Xi has far greater technological and economic resources at his disposal than Mao could have ever dreamed of.

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

Keynesian economic theory is useless if the aim is to understand how the world of human production and consumption works, but it is useful when attempting to figure out the policies that will be implemented in the future. The reason is that government and central bank policy-making is dominated by Keynesian ideas.

One of the most prominent Keynesian ideas is that changes in aggregate demand drive the economy. This leads to the belief that the government can keep the economy on a steady growth path by boosting its deficit-spending (thus adding to aggregate demand) during periods when economic activity is too slow and running surpluses (thus subtracting from aggregate demand) during periods when economic activity is too fast.

To further explain using an analogy, in the Keynesian world the economy is akin to a bathtub filled with an amorphous liquid called “aggregate demand”. When the liquid level gets too low it’s the job of the government and the central bank to top it up, and when the liquid level gets too high it’s the job of the government and the central bank to drain it off. Keynesian economics therefore has been called “bathtub economics”. The real-world economy is nothing like a bathtub, but that doesn’t seem to matter.

In any case, the point we now want to make is that in the US the traditional Keynesian guidelines are no longer being followed. Gone are the days of ramping-up government deficit-spending in response to economic weakness and running surpluses or at least reducing deficits when the economy is strong. These days the US federal government applies non-stop Keynesian-style stimulus and regularly exhorts the central bank to do the same. So, debt-financed tax cuts were implemented in 2017 when the economy seemed to be performing well, and now, with the unemployment rate at a generational low, the stock market near an all-time high and GDP growth chugging along at around 3%/year, the US government is planning a US$2 trillion infrastructure spending spree and the executive branch of the government is demanding that the Fed cut interest rates from levels that are already very low by historical standards.

In other words, although the ‘Keynesian bathtub’ appears to be almost over-flowing, the US government is pushing for more demand-boosting actions. The strategy is now full-on ‘stimulus’ all the time. That’s part of why it doesn’t make sense to be anything other than long-term bullish on “inflation” and long-term bearish on Treasury bonds.

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

Here is our monthly update on what’s happening on the monetary inflation front in a few different regions/countries.

The G2 (US plus euro-zone) monetary inflation rate dropped to a 10-year low in March-2019 and has now spent 19 months below the boom-bust threshold of 6%. Refer to the following chart for details.

The low rate of G2 monetary inflation stems from the very low rate of money-supply growth in the US. During March the year-over-year (YOY) rate of growth in euro supply was 7.6%, which although well down from a 2014 peak of 14% is still quite high. The rate of growth in US$ supply, however, was only 1.8%.

The slow (by modern standards) rate of G2 money-supply growth boosts the risk that a global recession will begin in 2019, but, as noted in the past, the monetary inflation rate is a long-term indicator that leads economic and financial-market conditions by amounts of time that can vary substantially from one cycle to the next. When attempting to predict the start time of the next recession we therefore rely on other leading indicators, three of which were discussed in last week’s Interim Update.

Australia’s monetary inflation rate has picked up a little over the past few months, but the country remains on the verge of monetary deflation.

The very slow money-supply growth has had an effect on Australia’s property market, in that over the past 12 months residential property prices have fallen by an average of 6.9% on a nationwide basis and 10.9% in Sydney (the largest and most expensive city in Australia). Refer to the article posted HERE for more detail.

Actually, the decline to near zero in Australia’s monetary inflation rate is both a cause and an effect of the slight (to date) deflation of the property investment bubble. Commercial banks have been making it more difficult for house buyers to obtain credit, leading to a pullback in prices and a slowdown in the pace at which new money is created.

In January-2019 the year-over-year (YOY) growth rate of China’s M1 money supply dropped to its lowest level since 1989. There was an insignificant up-tick in February, but the recent attempts by China’s government to promote credit expansion started to ‘bear fruit’ in March. Refer to the following chart for details.

We wonder if this is too little too late to kick-start a new surge in the demand for industrial commodities.

Hong Kong hasn’t escaped the general monetary-inflation slowdown. As illustrated below, the YOY rate of growth in HK’s M2 money supply has languished near a 10-year low in the 1%-4% range over the past several months.

Remarkably, HK’s low monetary inflation rate is yet to have a pronounced effect on the world’s most expensive real estate. Property prices dropped in HK during August-December of last year, but they rose in January and the majority view is that a rise to new highs is in store.

Due to the monetary backdrop, we think there’s a high risk of a double-digit decline in HK property prices over the next 12 months.

Almost everyone knows that the Bank of Japan (BOJ) has pumped a huge amount of money into the Japanese economy, so the lack of “price inflation” in Japan is something of a quandary. Analysts have let their imaginations run wild in an attempt to explain this strange set of circumstances, and the situation in Japan has even been cited as proof that increasing the money supply doesn’t cause prices to rise. However, anyone who didn’t blindly assume that the BOJ’s actions were leading to rapid money-supply growth and instead took the trouble to check what was actually happening to Japan’s money supply would quickly realise that explaining Japan’s lack of “price inflation” requires no stretch of the imagination. The fact is that Japan’s monetary inflation rate over the past 25 years has been consistent with an “inflation” rate of approximately zero.

The persistently low rate of monetary inflation in Japan is illustrated by the following chart. The chart shows that the YOY rate of increase in Japan’s M2 money supply averaged about 2% over the past 27 years and about 2.5% over the past 10 years. It is currently about 2.4%. Assuming productivity growth of 2%-3%, these money-supply figures are consistent with a flat general price level.

Note that QE in Japan is different from QE in the US. When the Fed implements QE it boosts the supply of bank reserves and the supply of money on a one-for-one basis (bank reserves aren’t counted in the money supply), but the BOJ’s QE adds far more to bank reserves than to the money supply. Note also that the Fed’s QE created a lot less “price inflation” than many people were expecting for the reasons outlined HERE.

The Japanese economy has benefited from the persistently slow rate of monetary inflation and the resulting stability of the currency, but at the same time it has been hurt by the massive diversion of resources to the government. The net result is an economy that isn’t exactly vibrant, but also isn’t that bad.

To summarise the above information, the pace at which new money is being created around the world remains unusually slow.

An increase in the amount of gold bullion held by GLD (the SPDR Gold Shares) and other bullion ETFs does not cause the gold price to rise. The cause-effect works the other way around and in any case the amount of gold that moves in/out of the ETFs is always trivial compared to the metal’s total trading volume. However, it is reasonable to view the change in GLD’s gold inventory as a sentiment indicator.

Ironically, an increase in the amount of physical gold held by GLD and the other gold ETFs is indicative of increasing speculative demand for “paper gold”, not physical gold. As I explained in previous blog posts (for example, HERE), physical gold only ever gets added to GLD’s inventory when the price of a GLD share (a form of “paper gold”) outperforms the price of gold bullion. It happens as a result of an arbitrage trade that has the effect of bringing GLD’s market price back into line with its net asset value (NAV). Furthermore, the greater the demand for paper claims to gold (in the form of ETF shares) relative to physical gold, the greater the quantity of physical gold that gets added to GLD’s inventory to keep the GLD price in line with its NAV.

Speculators in GLD shares and other forms of “paper gold” (most notably gold futures) tend to become increasingly optimistic as the price rises and increasingly pessimistic as the price declines. That’s the explanation for the positive correlation between the gold price and GLD’s physical gold inventory illustrated by the following chart. That’s also why intermediate-term trend reversals in the GLD gold inventory tend to follow reversals in the gold price. The thick vertical lines on the following chart mark the intermediate-term trend reversals in the US$ gold price.

Interestingly, the increase in the GLD inventory that occurred in parallel with the most recent upward trend in the gold price was relatively small. This suggests that the price rally was driven more by increasing demand for physical gold than by increasing demand for paper gold. Furthermore, the minor downward correction in the gold price since the February-2019 short-term peak has been accompanied by a disproportionately large decline in GLD’s physical inventory. In fact, at the end of last week GLD held about 30 tonnes less gold than it did when the gold price was bottoming in the $1170s last August. Again, this suggests that the gold price has been supported by demand for the physical metal.

In terms of influence on the gold price, speculative trading of gold futures is vastly more important than speculative trading of GLD shares. Therefore, assumptions about paper versus physical demand shouldn’t be based solely on the change in the GLD inventory. The situation in the gold futures market also must be taken into account.

I won’t get into the details in this post, but changes in futures-market positioning and open interest over the past few months are consistent with the idea that the demand for physical gold has been strong relative to the demand for paper gold.

The relatively strong demand for physical gold does not imply that a big gold-price rally is coming, but it does imply that the downside price risk is low.

If you look hard enough you will always be able to find reasons that the gold price is about to rocket upward, because such reasons always exist regardless of whether gold’s prospects are bullish or bearish. More generally, searching for reasons that something specific is about to happen is a bad way to speculate or invest because it will always be possible to find evidence to support any preconceived view. Rather than attempting to justify preconceived views, it is much better to approach the markets with an open mind and to base buy/sell decisions on objective indicators with good long-term track records.

One of the financial world’s most reliable indicators is the gold/commodity (g/c) ratio. The g/c ratio is more predictable than the US$ gold price, or to be more accurate the g/c ratio has a more consistent relationship with other markets than does the US$ gold price. This is possibly because removing the ever-changing dollar from the equation suppresses ‘noise’ and amplifies ‘signal’.

The following chart is an example of the g/c ratio’s consistent, and therefore predictable, relationship with another market. It shows that almost all of the time the g/c ratio (as represented by the US$ gold price divided by the GSCI Spot Commodity Index) trends in the same direction as credit spreads (represented here by the IEF/HYG ratio).

The relationship depicted below is sufficiently reliable that if you know, or at least have a good idea regarding, what will happen to credit spreads over a certain period, then you will be able to accurately forecast whether gold will strengthen or weaken relative to the average commodity over the period. By the same token, knowledge about whether gold is poised to strengthen or weaken relative to the average commodity leads to a high-probability forecast about credit spreads.

There are other inter-market relationships involving the g/c ratio that work just as well as the one mentioned above, and at the beginning of this year I used one of these to forecast that gold would be weak relative to commodities during the first half and strong relative to commodities during the second half of 2019. The first-half forecast has panned out to date. The second-half forecast still looks plausible but is subject to revision based on what happens to various indicators over the next couple of months.

Another of the financial world’s most reliable indicators is sentiment. An accurate reading of market sentiment doesn’t lead to specific conclusions about future price movements, and as discussed HERE there are pitfalls associated with using sentiment to guide buy/sell decisions. However, understanding how sentiment affects the markets can give an investor a decisive edge.

I’m not going to write about why or how sentiment can be used to good effect when attempting to time buys and sells in the financial markets. I’m also not going to mention the most useful indicators of market sentiment. The reason is that Bob Moriarty has covered this ground and more in his latest book: “Basic Investing in Resource Stocks: The Idiot’s Guide“. The Kindle version of the book is only US$6, or just a little more than the price of a large cappuccino at my local cafe.

Bob’s book is essential reading for anyone speculating in junior resource stocks, especially anyone who is inexperienced or hasn’t coped well with the huge swings in these stocks in the past.

At one point during the book I thought that Bob was making successful speculation in the stocks of small mining and oil companies seem too easy, because the hard reality is that even when you understand the most effective way to trade these stocks you still will stumble into traps from time to time. However, later in the book Bob warns the reader that large losses can happen even when all the ducks appear to be in a row. He does this by recounting some amusing stories about his own failed speculations and the management teams that helped to create these failures.

Even if you already know how to use sentiment and how to operate profitably at the speculative end of the stock market, you will get something out of the Bob Moriarty book linked above. It’s well worth the 6 bucks for the electronic version or the 12 bucks for the paper version.

A popular view is that the Fed has given up on monetary tightening and as a result the stock market should continue to trend upward over the months ahead. This view is based on flawed reasoning.

The reality is that the Fed possibly will give up on monetary tightening later this year, but currently the Fed is pulling quite firmly on the monetary reins via its on-going balance-sheet normalisation (that is, balance-sheet reduction) program. Moreover, the Fed’s on-going withdrawal of money from the economy is not being fully offset by the actions of the commercial banks, so the overall US money-supply situation is becoming increasingly restrictive. This is evidenced by the following chart of the year-over-year (YOY) change in US True Money Supply (TMS). The chart shows that in March-2019 the US monetary inflation rate made a 12-year low.

However, the unusually slow pace of US money-supply growth is not a good reason to be short-term bearish on the US stock market. This is partly because changes in the financial markets lag changes in the monetary backdrop by long and variable amounts of time. It is also because of a point that was covered in a TSI blog post about three weeks ago.

The point I’m referring to is that whether the overall monetary situation is ‘tightening’ or ‘loosening’ is not solely determined by the change in money supply. Instead, over periods of up to a few years the change in the demand for money (meaning: the change in the desire to hold/obtain cash as an asset) often will dominate the change in the supply of money.

In general terms, the change in overall liquidity is determined by the change in the supply of money relative to the change in the demand to hold cash or cash-like securities. As a consequence, it’s possible for the liquidity situation to be tight even if the monetary inflation rate is very high and/or rapidly increasing. A great example is the period from September-2008 to March-2009, when a large and fast increase in the US money supply was more than offset by a surge in the demand for money. Also, it’s possible for there to be abundant liquidity even if the monetary inflation rate is very low. A good example occurred over the past 3-4 months.

Although the supply side of the monetary equation tends to be dominated by the demand side of the equation over the short-to-intermediate-term, today’s unusually low monetary inflation rate is still significant. It means that only a small increase in the demand to hold cash could bring about another plunge in the stock market. To put it another way, due to the low monetary inflation rate the US stock market is far more vulnerable than usual to a short-term increase in risk aversion.

Taking a wider-angle view, the money-supply situation also leads to the conclusion that if a bear market did not begin last year (it most likely didn’t) then it will begin by the second half of next year at the latest. Other indicators will be required to narrow-down the timing.

[In a blog post last October I mentioned that a recent divergence between the gold/commodity ratio and the T-Bond price had bullish implications for the T-Bond. A strong rebound in the T-Bond soon got underway. Another divergence between the gold/commodity ratio and the T-Bond price has since developed, this time with bearish implications for the T-Bond. A discussion of the most recent divergence was included in a TSI commentary published on 28th March and is reprinted below.]

The gold/commodity (g/c) ratio and the T-Bond price tend to move in the same direction. As previously explained, this tendency is associated with what Keynesian economists call a paradox (“Gibson’s Paradox”) and Austrian economists call a natural and perfectly understandable consequence of the relationship between time preference and prices. The reason for revisiting the gold-bond relationship today is that a significant divergence developed over the past three months and such divergences are usually important.

The following chart illustrates our point that the gold/commodity ratio (the US$ gold price divided by the GSCI Spot Commodity Index) and the T-Bond price move in the same direction most of the time. It also shows that over the past three months the two quantities have diverged, with the g/c ratio trending downward while the T-Bond price extended its upward trend and moved to a marginal new 12-month high.

Given that the relationship between the g/c ratio and the T-Bond has a solid fundamental basis, that is, given that it’s not a case of random correlation, it should continue to apply. Therefore, we expect that the divergence will close over the months ahead — via either a rise in the g/c ratio to above its December-2018 high or a decline in the T-Bond price to well below its February-2019 low.

The divergence probably will close via a decline in the T-Bond price, because if there is a leader in this relationship it is the g/c ratio. For example, in each of the three biggest divergences of the past five years (the areas inside the blue boxes drawn on the above chart), the g/c ratio reversed course months in advance of the T-Bond. The g/c ratio also led the T-Bond by 2-3 months at the Q3-2017 top and by a couple of weeks at the Q4-2018 bottom. In other words, the recent performance of the g/c ratio is a reason to be intermediate-term bearish on the T-Bond.

One realistic possibility is that the T-Bond is now topping similarly to how it bottomed between December-2016 and March-2017. Back then, both the g/c ratio and the T-Bond turned up at around the same time (in late December of 2016), but whereas the g/c ratio trended upward throughout the first quarter of 2017 the T-Bond made a marginal new low in March before commencing an upward trend of its own. This time around the g/c ratio and the T-Bond turned down at around the same time (in late December of 2018), but whereas the g/c ratio has continued along a downward path the T-Bond has risen to a marginal new multi-month high.

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

The Quantity Theory of Money (QTM) holds that the change in money Purchasing Power (PP) is proportional to the change in the Money Supply (MS). It’s a bad theory, because it doesn’t reflect reality.

There are three main reasons that QTM doesn’t work in the real world, the first being that money PP can’t be expressed as a single number. There is no such thing as the “general price level”. Instead, at any point in time there are millions of individual prices that cannot be averaged to arrive at something sensible. That being said, QTM wouldn’t work even if it were possible to determine the “general price level”.

The second reason that QTM doesn’t work in the real world is that new money never gets injected uniformly throughout the economy. A consequence is that different prices get affected in different ways at different times, depending on who the first receivers of the new money happen to be. For example, during normal times the commercial banks are responsible for almost all money creation, with new money entering the economy via loans to the banks’ customers, whereas during 2008-2014 most new US dollars were created by the Fed and injected into the financial markets via the purchasing of bonds.

However, even if there existed a single number that accurately represented money PP and new money was injected uniformly throughout the economy, the Quantity Theory of Money STILL wouldn’t work. The reason is that as is the case with the price of anything, the price of money is determined by supply AND demand. (As an aside, in the real world there is no such thing as money velocity.) In other words, the price (PP) of money never could be properly explained/understood by reference to only the supply of money. We’ll now expand on this point.

Over the very long term, changes in money supply dominate changes in money demand, where by money demand we mean the desire to hold cash as an asset rather than the desire to obtain money to facilitate current purchases. However, during periods of up to a few years the change in money demand often will dominate the change in money supply. A good example is September 2008 through to March 2009. During this period the Fed rapidly increased the money supply, but the Fed’s actions were overwhelmed by increasing demand for money. Furthermore, when prices suddenly started rising in March-April of 2009 it was not only because the money supply had grown, but also because the demand for money had begun to fall.

In relation to the above it’s important to understand that in addition to affecting the supply of money, the Fed and other central banks affect the demand for money. This is very relevant to the recent past. Over the past three months the Fed continued to reduce the money supply, but statements emanating from the Fed had the effect of reducing the desire to hold cash. The net effect was a general increase in ‘liquidity’ even while the Fed acted to reduce the money supply.

Unfortunately, there is no way to analyse the monetary situation that is both simple and accurate. In particular, there is no simple equation that indicates the real-world relationship between money supply and money purchasing-power.

I haven’t discussed gold’s true fundamentals* at the TSI Blog since early December of last year, at which time I concluded: “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 $1300s early next year…” The “recent trend in the fundamental situation” did continue, enabling my Gold True Fundamentals Model (GTFM) to turn bullish at the beginning of this year (after spending almost all of 2018 in bearish territory) and paving the way for the US$ gold price to move up to the $1300s.

The following weekly chart shows that after moving slightly into the bullish zone (above 50) at the beginning of January, the GTFM has flat-lined (the GTFM is the blue line on the chart, the US$ gold price is the red line). Based on the current positions of the Model’s seven inputs, its next move is more likely to be further into bullish territory than a drop back into bearish territory.

As an aside, the bullish fundamental backdrop does not preclude some additional corrective activity in the near future.

The most important GTFM input that is yet to turn bullish is the yield curve, as indicated by the 10year-2year yield spread or the 10year-3month yield spread. This input shifting from bearish to bullish requires a reversal in the yield curve from flattening (long-term rates falling relative to short-term rates) to steepening (long-term rates rising relative to short-term rates). If the reversal is driven primarily by falling short-term interest rates it indicates a boom-to-bust transition, such as occurred in 2000 and 2007, whereas if the reversal is driven primarily by rising long-term interest rates it points to increasing inflation expectations.

As illustrated below, at the end of last week there was no evidence of such a trend change in the 10year-3month yield spread.

The US$ gold price could rise to the $1400s during the second quarter of this year as part of an intermediate-term rally, but to get a gold bull market there probably will have to be a sustained trend reversal in the yield curve.

*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.

[This blog post is a modified excerpt from a TSI commentary published about a month ago]

Modern Monetary Theory, or MMT for short, is gaining popularity in the US. It is based on the idea that under the current monetary system the government doesn’t have to borrow. Instead, it simply can print all the money it needs to fill the gap between its spending and its income. The only limitation is “inflation”. As long as “inflation” is not a problem the government can spend — using newly-created money to finance any deficit — as much as required to ensure that almost everyone is gainfully employed and to provide all desired services and infrastructure. It sounds great! Why hasn’t anyone come up with such an effective and easy-to-implement prosperity scheme in the past?

Of course it has been tried in the past. It has been tried countless times over literally thousands of years. The fact is that there is nothing modern about Modern Monetary Theory. It is just another version of the same old attempt to get something for nothing.

Most recently, MMT was put into effect in Venezuela. For all intents and purposes, the government of Venezuela printed whatever money it needed to pay for the extensive ‘free’ social services it promised to the country’s citizens. The MMT apologists undoubtedly would argue that the money-printing experiment didn’t work in Venezuela because the government didn’t pay attention to the “inflation” rate. It kept on printing money at a rapid pace after “inflation” became a problem. Our retort would be: “Great point! Who would have thought that a government with the power to print money couldn’t be trusted to stop printing as soon as an index of prices moved above an arbitrary level.”

In essence, MMT is based on the fiction that the government can facilitate an increase in overall economic well-being by exchanging nothing (money created ‘out of thin air’) for something, or by enabling the recipients of the government’s largesse to exchange nothing for something. It is total nonsense, although there is an obvious reason that it appeals to certain politicians. Its appeal to the political class is that it superficially provides an easy answer to the question that arises when politicians promise widespread access to valuable services free of charge. The question is: “Who will pay?” According to MMT, nobody pays until/unless “inflation” gets too high.

And what happens when inflation gets too high? Well, according to MMT the government simply ramps up direct taxation to reduce the spending power of the private sector, which supposedly quells the upward pressure on prices.

Therefore, MMT can be viewed as a case of heads the government wins, tails the private sector loses. As long as “inflation” is below an arbitrary level the government can extract whatever wealth it wants from the private sector indirectly by printing money, and if “inflation” gets too high the government can extract whatever wealth it wants from the private sector via direct taxation.

The crux of the issue is that new wealth can’t be created by printing money, but existing wealth will be redistributed. It’s like when a private counterfeiter prints new money for himself. When he spends that money he diverts real wealth to himself while contributing nothing to the economy. MMT is the same principle applied on a gigantic scale.

That being said, MMT does have its good points, just not the good points that its proponents claim.

As happens when money is loaned into existence under the current system, the application of MMT will affect relative prices as well as the so-called “general price level”. The reason is that the new money won’t be injected uniformly across the economy. However, it’s likely that the price increases stemming from the monetary inflation will be more uniform and direct under MMT than under the current system. In other words, under MMT the effects of monetary inflation should be reflected much sooner and to a far greater extent in the CPI than is the case with the current system.

That the application of MMT would lead quickly to what most people think of as “inflation” is a benefit, because the link between cause (monetary inflation) and effect (rising prices) would be obvious to almost everyone. A related benefit is that MMT would short-circuit the boom-bust cycle.

Booms happen when the Fractional Reserve Banking (FRB) system (with or without a central bank) expands credit and in doing so creates the impression that the quantity of real savings is much greater than is actually so. This prompts excessive investment in long-term business ventures that would not look viable in the absence of misleading interest-rate signals.

We assume that under MMT the commercial banks still would be lending new money into existence, but the temporary downward pressure on interest rates from the surreptitious money creation of the banks would be more than offset by the upward pressure on interest rates from the blatant money-printing of the government. The boom phase therefore would be very short, perhaps even barely noticeable. In effect, MMT would bypass the boom and go straight to the bust. Again, this would be beneficial because it would expose the link between cause (the application of a crackpot monetary theory) and effect (economic hardship for most people).

MMT is such an obviously silly idea that any economist, politician, journalist or financial-market commentator who advocates it should not be taken seriously. However, that they are being taken seriously opens up the possibility that MMT will be implemented in the not-too-distant future, with the ‘benefits’ outlined above.