A few years ago I wrote a couple of pieces explaining why gold mining is a crappy business. The main reason is the malinvestment that periodically afflicts the industry due to the boom-bust cycle caused by monetary inflation.

To recap, when the financial/banking system appears to be in trouble and/or economic confidence is on the decline, the perceived value of equities and corporate bonds decreases and the perceived value of gold-related investments increases. However, gold to the stock and bond markets is like an ant to an elephant, so the aforementioned shift in investment demand results in far more money making its way towards the gold-mining industry than can be used efficiently. Geology exacerbates the difficulty of putting the money to work efficiently, in that gold mines typically aren’t as scalable as, for example, base-metal mines or oil-sands operations.

In the same way that the malinvestment fostered by the creation of money out of nothing causes entire economies to progress more slowly than they should or go backwards if the inflation is rapid enough, the bad investment decisions fostered by the periodic floods of money towards gold mining have made the industry inefficient. That is, just as the busts that follow the central-bank-sponsored economic booms tend to wipe out all or most of the gains made during the booms, the gold-mining industry experiences a boom-bust cycle of its own with even worse results. The difference is that the booms in gold mining roughly coincide with the busts in the broad economy.

Gold, itself, is not afflicted by the rampant malinvestment that periodically occurs within the gold-mining sector. Regardless of what’s happening in the world, an ounce of gold is always an ounce of gold. It is neither efficient nor inefficient; it just is.

A consequence is that gold bullion increases in value relative to gold-mining stocks over the long term. This is evidenced by the fact that the gold-mining sector, as represented on the following chart by the Barrons Gold Mining Index up to 1996 and the HUI thereafter, has been in a downward trend relative to gold bullion since 1968. 1968!!

Yes, we are talking about a 50-year downward trend in the value of gold-mining stocks relative to gold bullion. For how many more decades will this trend have to continue before analysts stop referring to gold-mining stocks as leveraged plays on the metal?

There’s no reason to expect the above trend to end while the current monetary system is in place. This doesn’t mean that gold-mining stocks should be ignored, as these stocks can generate huge profits for traders who remember to sell when the selling is good. It means that if you want long-term exposure to gold then you should own gold, not the stocks of companies that mine gold.

[This post is a modified excerpt from a TSI commentary published last month]

Although I’m not in total agreement with it, I can highly recommend Erik Norland’s article titled “Gold: At the Crossroads of Fiscal and Monetary Policies.” The article is informative and, unlike the bulk of gold-related commentary, actually deals with fundamental developments that could be important influences on gold’s price trend.

The article was published in early-May and states that the U.S. is in a mid-to-late stage recovery. While that statement was probably correct at the time, evidence has since emerged that the economy has entered the “Late-Expansion” stage.

Note that the “Late-Expansion” stage could extend well into 2019 or perhaps even into 2020 and that the best leading indicators of recession should issue timely warnings when this stage is about to end. By the way, the extension of the Late-Expansion stage is why the industrial metals markets probably will commence new intermediate-term rallies later this year.

My only substantial disagreement with the above-linked article is associated with the relationship between gold and fiscal policy. Parts of the article are based on the premise that expansionary fiscal policy and its ‘ballooning’ effect on federal debt are bullish for gold. This premise is false; expansionary fiscal policy is not, in and of itself, either bullish or bearish for gold.

The effects that fiscal policy and the associated change in government debt have on the gold price will be determined by their effects on economic confidence. Of particular relevance, there’s no good reason to assume that an increase in government debt will bring about a decline in economic confidence, which is what it would have to do to be bullish for gold. In fact, if an increase in government indebtedness is largely the result of reduced taxes then it could lead to increased economic confidence for a considerable time and thus put DOWNWARD pressure on the gold price.

That there should not be a consistent positive correlation between the gold price and the extent of US government indebtedness is borne out by the empirical evidence. In particular, the following chart shows that there was a NEGATIVE correlation between the US$ gold price and the US government-debt/GDP ratio between 1970 and 1995, with debt/GDP drifting lower during the long-term gold bull market of the 1970s and then trending upward during the first 15 years of gold’s long-term bear market.

The wrong assertion that an increase in the government’s debt burden is necessarily bullish for gold appears to rely on what happened during 1995-2011, in that during this 17-year period there was a positive correlation between the gold price and the US government-debt/GDP ratio. You must take a wider-angle view to realise that this 17-year period is an example of correlation not implying causation. The fact is that over the past 50 years the overarching correlation between the gold price and the debt/GDP ratio has been negative for more time than it has been positive.

The steadfast belief that rising US government debt is bullish for the US$ gold price is similar to the steadfast belief that geopolitical conflict is bullish for the gold price. They are both superstitions. The gold price has never made sustainable gains in reaction to international military conflict or the threat of the same, and the gold price is just as likely to fall as it is to rise in parallel with increasing government indebtedness.

The lagged response of the economy to the central bank’s monetary machinations is the key to long-term trends in the gold price. Therefore, it isn’t correct to say that gold is at the crossroads of fiscal and monetary policies (the theme of the above-linked article). It is correct, however, to say that gold is at the crossroads of bubble activities and the reduction of monetary fuel to support such activities.

The current US economic boom is like the cartoon character that has run over the edge of a cliff, but hasn’t looked down yet. The character can continue running without any support as long as it doesn’t look down. At this stage, investors in stocks, bonds and other assets that have been propelled to sky-high valuations by monetary inflation are acting as if the temporary props put in place by the central bank still exist, so they don’t yet perceive the need for the support that gold can offer. Unfortunately, unlike in the cartoons when the time from running over the cliff to the point of recognition is always a few seconds or less, there’s no way to know in advance how long an artificial economic boom will persist after the monetary support is removed.

In a couple of blog posts last year I discussed the limitations of sentiment as a market timing tool. With the most reliable sentiment indicators now revealing extreme negativity towards gold, it’s timely to revisit this topic using the current gold market situation as an example.

There are two sentiment pitfalls that I mentioned in the earlier posts that are especially relevant to the current gold-market situation. The first is linked to the fact that sentiment generally follows price, making it a near certainty that the overall mood will be at an optimistic extreme near an important price top and a pessimistic extreme near an important price bottom. Putting it another way, there is nothing like a strongly-rising price to get the speculating community and the general public bullish and there is nothing like a steep price decline to get them bearish, so it’s perfectly natural that price-tops will be associated with optimism and price-bottoms will be associated with pessimism. The problem is that while an important price extreme will always be associated with a sentiment extreme, a sentiment extreme doesn’t necessarily imply an important price extreme.

Gold’s current Commitments of Traders (COT) situation shows that relative to the past 15 years, speculative sentiment is now at a pessimistic extreme. This implies that there is now plenty of sentiment-related fuel to propel the gold price upward over the months ahead, but it doesn’t imply that the price is close to a sustainable low. If the price continues to trend downward then speculators, as a group, will continue to lose interest in being long and gain interest in being short. Of course, when a sustainable price bottom is reached it WILL coincide with very negative sentiment, because, as I said, sentiment follows price.

The second potential pitfall is that what constitutes a sentiment extreme will vary over time, meaning that there are no absolute benchmarks. In particular, what constitutes dangerous optimism in a bear market will often not be a problem in a bull market and what constitutes extreme fear/pessimism in a bull market will often not signal a good buying opportunity in a bear market.

At the moment, gold is not in a bull market. It is either still immersed in the bear market that began in 2011 or immersed in a long-term basing pattern. Either way, it isn’t reasonable to blindly assume that what constituted a sentiment extreme during the period since 2001, the bulk of which involved a gold bull market, constitutes a sentiment extreme today.

If we look back further than 2001 we see that the current speculative positioning in gold futures is not necessarily indicative of an extreme. For example, the following chart from goldchartsrus.com shows that speculators in Comex gold futures were consistently net-short during 1996-2001.

My guess is that the gold price will rebound strongly from whatever low it makes during August-September. However, unless the fundamentals make a sustainable turn in gold’s favour (right now the fundamental backdrop is unequivocally bearish for gold) it’s likely that at some future point the COT data for gold will reveal much greater negativity on the part of the speculating community than exists today.

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

During the first three quarters of 2016 we were open to the possibility that a new cyclical gold bull market got underway in December of 2015, but over the past 18 months we have been consistent in our opinion that the December-2015 upward reversal in the US$ gold price did NOT mark the start of a bull market. Since late-2016 there have been some interesting rallies in the gold price, but at no time has there been a good reason to believe that we were dealing with a bull market. That’s still the case. The question is: what will it take to set a new cyclical gold bull market in motion?

The simple answer is that it will take a US equity bear market. However, this is not a practical answer because in real time there often will be no way of differentiating the first 6-9 months of an equity bear market from an intermediate-term bull-market correction. The most practical answer we can come up with is that it will take an upward reversal in the yield curve.

It has become popular to argue that due to extraordinary monetary policy the yield curve is not as important as it was in the past, but we strongly disagree. In our opinion the yield curve is, if anything, more important now — in the face of extraordinary monetary policy — than it has ever been.

The potential for the US yield curve to invert in the not-too-distant future is a red herring. Except to the extent that it influences the psychology of senior Fed officials, whether or not the curve inverts is neither here nor there. It’s the reversal from ‘flattening’ to ‘steepening’ that matters, regardless of whether the reversal happens before or after the curve inverts.

If the next major reversal of the yield curve is driven primarily by falling short-term interest rates then it will signal the onset of an economic bust. An economic bust would naturally coincide with an equity bear market and the start of a gold bull market. On the other hand, if the next major reversal of the yield curve is driven primarily by rising long-term interest rates then it will signal the onset of an inflationary blow-off that likely would go hand-in-hand with a powerful 1-2 year rally in the gold price and the prices of most other commodities.

Last week the 10yr-2yr yield spread, a proxy for the US yield curve, fell to within 2 basis points of the 10-year low reached in mid-July. Therefore, at this time there is no sign of an upward reversal.

For the first time this year, about two weeks ago the sentiment backdrop became decisively supportive of the gold price and remains so. At the same time, the fundamental backdrop is unequivocally bearish for gold. What will be the net effect of these counteracting forces?

Before attempting to answer the above question let’s briefly review the most important sentiment and fundamental indicators.

The following chart from goldchartsrus.com shows that at Tuesday 7th August (the date of the latest COT data) the net positioning of traders in gold futures was similar to what it was in December-2015, which is when a powerful 7-month rally was about to begin. Therefore, in terms of net positioning the COT situation (the most useful of all the gold-market sentiment indicators) is as bullish as it has been in many years.

The one concern is that while the open interest (the green bars in the bottom section of the following chart) is well down from where it was a month ago, it is still more than 50K contracts above where it was at the December-2015 and December-2016 price lows (the two most important price lows of the past five years). The open interest may have to drop to 400K contracts or lower before there is a strong, multi-month rally.

There are a number of important fundamental drivers of the US$ gold price, including credit spreads, the yield curve, the real interest rate (the TIPS yield), the relative strength of the banking sector and the US dollar’s exchange rate. The most important seven gold-market fundamentals are incorporated into our Gold True Fundamentals Model (GTFM), a chart of which is displayed below.

The GTFM was ‘whipsawed’ between late-June and mid-July, in that during this short period it shifted from bearish to bullish and then back to bearish. Apart from this 2-3 week period it has been continuously bearish since mid-January.

Returning to the question posed in the opening paragraph, regardless of what happens on the sentiment front there will not be an intermediate-term upward trend in the gold market until the fundamental backdrop turns gold-bullish. The fundamentals are constantly in flux and potentially will turn bullish within the next few weeks, but at this time there is no good reason to expect that an intermediate-term gold rally is about to begin.

However, with the right sentiment situation a strong short-term rally can occur in the face of bearish fundamentals. This is what happened between late-June and early-September of 2013. During this roughly 2-month period there was a $200 increase in the gold price in the face of a gold-bearish fundamental backdrop.

The gold market was far more ‘oversold’ in late-June of 2013 than it is today, but it is sufficiently depressed today to enable a short-term rebound of at least $100 even without a significant improvement (from gold’s perspective) in the fundamentals.

That doesn’t mean that we should expect a $100+ rebound to get underway in the near future, only that — thanks to the depressed sentiment — the potential is there. Before the potential starts being realised the price action will have to signal a reversal.

The US yield curve, as indicated by the spread between the 10-year and 2-year T-Note yields, made a new 10-year extreme over the past fortnight, meaning that it recently became the ‘flattest’ it has been in more than 10 years. While this may indicate that the boom is nearing its end, it definitely indicates that the transition from boom to bust has not yet begun.

As explained numerous times in the past, the ‘flattening’ of the yield curve (short-term interest rates rising relative to long-term interest rates) is a characteristic of a monetary-inflation-fueled economic boom. It doesn’t matter how flat the yield curve becomes or even if it becomes inverted, the signal that the boom has ended and that a bust encompassing a recession is about to begin is the reversal of the curve’s major trend from flattening to steepening. To put it another way, the signal that the proverbial chickens are coming home to roost is short-term interest rates peaking RELATIVE TO long-term interest rates and then beginning to decline relative to long-term interest rates. This generally will happen well before the Fed sees a problem and begins to cut its targeted short-term interest rate.

The following chart highlights the last two major reversals of the US yield curve from flattening to steepening. These reversals were confirmed about 6 months prior to the recessions that began in March-2001 and December-2007.

The fact that the yield curve is still hitting new extremes in terms of ‘flatness’ suggests that the next US recession will not begin before 2019.

The above is essentially a repeat of what I’ve written in the past, but an additional point warrants a mention. The additional point is that while it would be almost impossible for the US economy to transition from boom to bust without a timely reversal in the yield curve from flattening to steepening, there is a realistic chance that the next yield-curve trend reversal from flattening to steepening will NOT signal the onset of an economic bust/recession. That’s why I do not depend solely on the yield curve when determining recession probabilities.

The reason that the next yield-curve trend reversal from flattening to steepening will not necessarily signal the onset of an economic bust/recession is that there are two potential drivers of such a reversal. The reversal could be driven by falling short-term interest rates or rising long-term interest rates. If it’s the former it signals a boom-bust transition, but if it’s the latter it signals rising inflation expectations.

As an aside, regardless of whether a major yield-curve reversal from flattening to steepening is driven by the unravelling of an artificial boom or rising inflation expectations, it is bullish for gold. By the same token, a major reversal in the yield curve from steepening to flattening is always bearish for gold.

With the T-Bond likely to strengthen for at least the next two months there is little chance that rising long-term interest rates will drive a yield curve reversal during the third quarter of this year, but it’s something that could happen late this year or during the first half of next year.

Governments and central banks lost interest in the gold price decades ago, but stories about how governments are supposedly controlling the gold price never lose their appeal. One of the latest stories is that since the inclusion of the Yuan in the IMF’s SDR (Standard Drawing Rights) basket in October-2016, the Chinese government has pegged the SDR-denominated gold price to 900 +/- a few percent. According to The Macro Tourist’s 25th July blog post, this story has been told by Jim Rickards. The Macro Tourist suggests a different story*, which involves the Chinese government (or someone else) having pegged the Yuan-denominated gold price. Both stories are based on gold’s narrow trading range relative to the currency in question over the past two years.

If we are going to play this game then I can tell an even better story. My story is that the Japanese government took control of the gold market in early-2014 and has since been keeping the Yen-denominated gold price at 137,000 +/- 5%. They lost control in early-2015 and again in early-2018, but in both cases they quickly brought the market back into line.

Here’s the chart that ‘proves’ my version of events:

The narrow sideways range of the Yen gold price over the past 4.5 years is due to the Yen being the major currency to which gold has been most strongly correlated. Here’s a chart that illustrates the strong positive correlation between Yen/US$ and gold/US$:

My story about the Japanese government pegging the gold price makes as much sense as the stories about the Chinese government pegging the gold price. That is, my story makes no sense.

It will be possible to find price data to substantiate almost any manipulation story. Also, with sufficient imagination there is no limit to the manipulation stories that can be concocted to explain any price action. For example, you can always look at a period of range-trading in the gold market and conclude that a government (the same organisation that makes a mess of everything else it tries to do) is adeptly managing the price. Alternatively, you can look for a more plausible explanation or perhaps just acknowledge that not all price action has a single, simple explanation.

Like all financial markets the gold market is, of course, manipulated, but even if there were a desire to do so (there isn’t) it would not be possible under today’s monetary system for any government to directly control the gold price over a period of years or alter major trends in the gold price.

*In general the Macro Tourist blog provides level-headed commentary on the financial markets and doesn’t plunge into the murky world of gold-manipulation story-telling. Even in this case I think the main point of the post is to show that gold is stretched to the downside and may be good for a short-term trade, but some people will take the post as more evidence that the gold market is dominated by nefarious forces.

Page 4 in Hoisington Investment Management’s latest Quarterly Review and Outlook contains a discussion about the falling productivity of debt problem. According to Hoisington and many other analysts, the problem is encapsulated by the falling trend in the amount of GDP generated by each additional dollar of debt, or, looking from a different angle, by the rising trend in the amount of additional debt required to generate an additional unit of GDP. However, there are some serious flaws in the “Productivity of Debt” concept.

There are three big problems with the whole “it takes X$ of debt to generate Y$ of GDP” concept, the first being that GDP is not a good indicator of the economy’s size or progress.

For one thing, GDP is a measure of spending, not a measure of wealth creation. It’s possible, for example, for GDP to grow rapidly during a period when wealth is being destroyed on a grand scale. This could happen during war-time and it could also happen as the result of massive government spending on make-work projects. It’s also possible for GDP to grow slowly at a time when the rate of economic progress is high. This can happen because GDP is dominated by consumption. It omits all business-to-business expenditure and misses a lot of value-adding investment.

For another thing, GDP is strongly influenced by changes in the money supply. Of particular concern, even though an increase in the money supply cannot possibly cause a sustainable increase in economy-wide wealth, it will usually boost GDP.

Therefore, comparing anything with GDP is problematic.

The second flaw in the “it takes X$ of debt to generate Y$ of GDP” concept is that it involves comparing a flow (annual GDP) to a stock (the cumulative total of debt). There are times when it can make sense to compare a stock to a flow, but care must be taken when doing so. I’ll use a hypothetical example to show one of the pitfalls.

Assume that over the course of a year an economy goes from a GDP of $10T and a total debt of $50T to a GDP of $10.4T and a total debt of $52T. This could prompt the claim that it took $2T of additional debt to boost GDP by $0.4T, or that $5 of additional debt was needed for every $1 of additional GDP. However, it could also be said that a 4% increase in debt was associated with a 4% increase in GDP. The second way of expressing the same change seems far less worrisome.

In any case, the above two flaws in the typical productivity-of-debt analysis pale in comparison with the third flaw, which is that the entire concept of debt productivity is meaningless. The fact is that debt doesn’t cause economic growth and ‘excessive debt’ (whatever that is) doesn’t inhibit economic growth.

An economy can grow with or without an increase in debt, because per-capita economic growth is caused by savings and capital investment. An increase in debt can accelerate the pace of real growth by acting as a means by which savings are channeled to where they can be invested to the best effect, but the transfer of savings can also occur via the exchange of money for equity. For example, most exploration-stage mining companies and most technology start-ups are equity-financed not debt-financed. There is, of course, debt that is used to finance consumption rather than investment, but that type of debt can’t grow the economy over the long term because it necessarily involves a present-future trade-off — more spending in the present leads to less spending in the future.

The central problem is unsound money, not excessive debt. More specifically, the problem is that when banks make loans they create money out of nothing. It’s this creation of money out of nothing and the subsequent exchange of nothing for something, not the build-up of debt, that leads to reduced productivity. If all debt involved the lending/borrowing of real savings then no amount of debt could ever make the overall economy less efficient. Of course, if all debt involved the lending/borrowing of real savings then the total amount of debt would be a small fraction of what it is today.

[This is a brief excerpt from a commentary posted at TSI last week]

In the 2nd July Weekly Update we discussed the risk posed by the recent weakening of China’s currency (the Yuan), and commented: “We won’t know for sure until China’s central bank publishes its international currency reserve figure for June, but the recent weakening of the Yuan does not appear to be the result of a deliberate move by China’s government.” We now know for sure — the Yuan’s pronounced weakness during the month of June was NOT the result of government manipulation. In fact, it can be more aptly described as the result of an absence of manipulation.

We know that this is so because of what happened to China’s currency reserves in June. As indicated by the final column on the following chart, almost nothing happened (there was no significant change). This means that China’s government made no attempt to either strengthen or weaken its currency last month.

To further explain, for China’s government to engineer weakness in the Yuan’s foreign exchange value it must add to its international currency reserves by exchanging its own currency (that it creates ‘out of thin air’) for foreign currency. By the same token, for China’s government to increase the Yuan’s relative value it must use its international currency reserves to purchase Yuan. Consequently, periods when China’s currency reserve is increasing are periods when China’s government is attempting to weaken the Yuan and periods when China’s currency reserve is decreasing are periods when China’s government is attempting to strengthen the Yuan.

The above chart therefore tells us that China’s government was trying to weaken the Yuan up to mid-2014 and strengthen the Yuan from mid-2014 until the end of 2016. The chart also seems to indicate that there was a tentative attempt to weaken the Yuan during 2017, but 2017′s gradual increase in China’s foreign currency stash was most likely driven by changing market valuation. We are referring to the fact that because reserves are reported in US dollars and held as debt securities, the reported value of the reserves can be altered by a change in exchange rates or bond prices. In particular, the reported reserve figure will have an upward bias during periods when the US$ is weak relative to other major currencies, as it was throughout 2017.

The bottom line is that China’s government has not yet weaponised the Yuan’s FX value in its economic war with the US government, but it is also not standing in the way when the Yuan weakens in response to market forces.

As I’ve noted in the past, the Commitments of Traders (COT) information is nothing other than a sentiment indicator. Moreover, for some markets, including gold, silver, copper, the major currencies and Treasury bonds, the COT reports are by far the best indicators of sentiment. This is because they reflect how the broad category known as speculators is betting. Sentiment surveys, on the other hand, focus on a relatively small sample and are, by definition, based on what people say rather than what they are doing. That’s why for some markets, including the ones mentioned above, I put far more emphasis on the COT data than on sentiment surveys.

In this post I’ll summarise the COT situations for five markets with the help of charts from “Gold Charts ‘R’ Us“. I’ll be focusing on the net positioning of speculators in the futures markets, although useful information can also be gleaned from gross positioning and open interest.

Note that what I refer to as the total speculative net position takes into account the net positions of large speculators (non-commercials) and small traders (the ‘non-reportables’) and is the inverse of the commercial net position. The blue bars in the middle sections of the charts that follow indicate the commercial net position, so the inverse of each of these bars is considered to be the total speculative net position.

I’ll start with gold.

Gold’s COT situation was almost unchanged over the latest week. Ignoring everything except sentiment (as indicated by the COT data), gold is in a similar position now to where it was in early-July and early-December of last year. This suggests the potential for a 2-month rally to the $1350-$1400 range, but not much more than that.

Silver’s COT situation has been a source of controversy over the past four months. Some analysts argued that it was extremely bullish, whereas I argued (for example: HERE) that at no point over this period was the COT situation conducive to a significant silver rally. I’m therefore not surprised that there hasn’t been a significant silver rally.

Four weeks ago silver’s COT situation became slightly bearish, but it has since improved and I now view it as neither a tail-wind nor a head-wind for the silver price. However, silver will rally if gold rallies. It’s that simple.

Four weeks ago the speculative net-long position in Comex copper futures became extreme. This didn’t guarantee that a large price decline was in store, but it pointed to substantial downside risk in the price.

Copper’s COT situation is now similar to what it was near short-term price bottoms in July and December of last year, so there’s a decent chance of a multi-week price rebound.

Of the major currencies, the Swiss franc (SF) has the most bullish COT situation. The COT information certainly doesn’t preclude one more decline in the SF to a new low for the year, but it suggests that the SF will trade significantly higher within the next three months.

I expect that long-dated US Treasury securities will trade at much lower prices (much higher yields) within the next 2 years, but during April-May of this year I began to anticipate a multi-month price rebound (yield pullback) in this market. This was mainly due to sentiment as indicated by the COT situation. Of particular relevance, the total speculative net-short position in 10-year T-Note futures had risen to an all-time high.

Despite a price rebound from the May low, the speculative net-short position in 10-year T-Note futures remains near the all-time high reached in late-May. Therefore, it’s a good bet that the T-Note/T-Bond price rebound is not close to being complete.