Weekly Gold Market Outlook
A Gold & Currency Digest
(Excerpts from Ed Bugos report dated 06-Oct-05)
Rationalism in the Gold Price
Note the recent decoupling in gold and Dow trends in the graphs to the right. This could be significant, as it argues for a return to normal counter-cyclicality for the relationship. Also, gold bulls may find comfort in the fact that the US dollar index is up so much off its lows; it allows for the prospect of more downside in its foreign exchange value than there was in December of last year, and again March of this year, when it was flirting with 10 year lows against a basket of other major currencies… not that it is at all necessary at this point in the move as we've said. But the (gold) market was smart enough then to know not to rally further while the US dollar was oversold and bouncing around its long term support levels - hence gold prices peaked at about US$455 in early December and were one month into their correction before the USd index bottomed. This fact simply underscores the view that gold moves tend to lead currency fluctuations, which is reasonable if you believe gold traders aim at anticipating money and currency values more so than any other commodity trader.
This fact alone could go a long way in explaining the resilience of gold prices this year to the best rally that the US dollar has put on since it started to reel in 2002… everyone knew it was coming!?
Of course, the reality is that the market is just taking care of some unfinished business. Declines in the real (gold) value of foreign currencies were postponed for most of the past three years as stock prices soared everywhere, taking investors eyes off the fact that they were soaring primarily because the foreign central banks were inflating at two or three times the rate that the Fed was; and the USd gold price, while rising, since the beginning of 2004 tended to rise less than most of the other commodities and most of the North American stock market averages, reflecting some extent of contraction in inflation fears on this continent as well.
In other words, we've argued all along that gold values continued to underestimate the true inflation reality (were held back), and that this would change once we saw weakening stock prices.
Thus, the foreign currency price of gold is only now factoring the past three years of foreign central bank inflation (in money) while the USd gold price is busy catching up to the other commodities, and beginning to anticipate the next inflation push by the Fed.
All of our markets appear to be conforming to our intermediate outlooks so far - from the multi-currency break away in gold prices and their outperformance of other assets, commodities and currencies, to the weakness in oil prices as well as stock and bond prices, to the observable fact that gold has decoupled from the Dow and fluctuations in the FX value of the USd (as it should we argue).
I'm only puzzled that anyone would think that what the Fed is doing is any sort of display of resolve at all.
September: Betting Against the Fed's Resolve September saw gold prices make fresh 17 year highs as the salvo of hurricanes that bombarded the eastern seaboard caused an energy spike and intensified speculation - already underway due to weakening stock prices and economic fundamentals - that the Fed was near the end of its so-called tightening cycle.
We saw copper and natural gas prices make new record highs (following on record highs in oil and gas prices in the previous month), and contrary to what you would hear from the FRB faithful press we saw breadth in the commodity complex widen to include significant rallies in lumber, platinum, palladium, wheat and even livestock futures - only the cocoa, coffee, corn and soybean declines checked an all out commodity advance.
The CRB itself rose only marginally on the month as the spike in energy and lumber prices during August simply spread out to the rest of the complex in September after driving the index to new 25 year highs (within two points of making all time highs).
The action was so bullish that perpetually bearish gold analysts at Virtual Metals were forced to finally turn bullish themselves.
All of this occurred despite the 4 percent rally in the US dollar (after two months of backfilling) and the back up in bond yields by about 20 to 40 basis points, depending on which bonds one is looking at. In fact, the returning inflation premium was not only apparent in the gold ratios (i.e. the outperformance of gold in general), but also in the very fact that bond yields continued to rise despite weak stock prices and firmer dollar values.
Sure, one could argue that bond yields went up because the market did not expect the Fed to hike the Fed Funds rate by another 25 basis points; but I don't think it's a good argument since everyone knows that the Fed Funds futures contracts suggested otherwise in the weeks leading up to September's FOMC. Even I said it was likely they'd do it. But I doubt anyone would argue that the word "inflation" has returned to the forefront of traders' minds. So enough said about that.
Frankly I think people are putting too much weight on the significance that each FOMC holds. Are we forgetting why they are doing this gradually in the first place? If you want to remove accommodation just do it. The way that I see it, there aren't any hawks at the Fed to worry about because they are all afraid of undertaking a real tightening program with the stock market averages trading in the nose bleed section… near 20x earnings.
Consequently, it doesn't really matter to my inflation outlook if short term interest rates are on the rise because I am confident that any sustainable increase in real interest rates (i.e. full compensation for the perceived loss in the value of money would be where the natural rate would be but an increase in real rates means beyond that) would both test and break the political will required to sustain it, at least at the short end where the Fed reigns.
I wouldn't be surprised if that partly explained the flatter yield curve this year, too. In other words, bond buyers may see the rate hike campaign as temporary for whatever reason. The psychology that has been conditioned in them by 20+ years of falling interest rates or yields is such that if they were anticipating the Fed to lower rates they would buy bonds expecting longer term yields (further out on the curve) to fall also. But prices aren't acting like they were in the disinflationary eighties and nineties. The last two years may have been a boon to copper, oil and gas prices in particular, but since 2000 we've seen record spikes occur at different times in palladium, platinum, silver, natural gas, wheat, cocoa, real estate, and so on. These are not isolated external events; they are the characteristic feature of the kind of inflationist economy we work in. The point is that psychological shifts regarding inflation expectations that cause major trend changes in interest rates change only slowly; but we have had five years of this and people are beginning to (correctly) think that there's no end to it. The question people should be asking at this point is not whether but which commodity or asset prices will spike next.
My answer is gold and wheat.
Anyway, we must be getting close to the point where investors realize there is nothing transitory about these price increases and decide that a 4% yield just won't cut it anymore. Now here's the key to this hypothesis: it is in the Fed's interest to see this new psychology evolve if it wants to inflate without dropping interest rates; this way as yields rise across the board and the Fed tightens slower than the markets, the yield curve will steepen - reflecting a timid Fed and a bond market that is losing some confidence in its policies. Such a state of affairs could continue for a while provided the new psychology doesn't get too ingrained and end up causing a crisis.
In other words, "real" interest rates won't increase much until inflation is overvalued!
The current run may be near to completing for most commodities because I think they're extended, but barring a major shift in public opinion about central banking you can bet it'll simply be the first primary interruption.
Obviously on days/weeks when the CRB or oil is down significantly gold is likely to dip.
But it didn't do this on Thursday. In fact there was the opposite effect. Not only was oil down but it broke down out of the two month head & shoulders top I referred to in the last issue on Thursday. Yet gold shot up $9. This empirical fact runs counterintuitive to what most analysts have been expecting: that falling oil would weigh on gold prices. Maybe it's already in the market.
Or maybe instead of the oil price fall drawing traders that recently sold their oil longs and went long gold back into their oil position, traders reckoned it was a genuine break down and sold more of their oil for gold instead. Of course that's only one dynamic and I'm only speculating (which should highlight the weakness in the positivist doctrine - the data don't tell me anything for sure; it's subject to my interpretation / preexisting theory).
Anyhow this decoupling further strengthens our hypothesis about gold taking the lead from here, and by all indications the market seems to also be betting against the Fed's resolve. I think that is the correct bet today.
Long Run Gold Funnymentals
- Political and economic dependency on inflation (or easy credit) & interventionism around the world that has become increasingly manifest (as always once started) - due to general ignorance! - its progression is ultimately bound to undermine the productivity gains that have kept consumer price increases tame so far (just consider the changes at the Fed - from inflation fighter in the early nineties to easy Al today - never mind the changes to the budget psychology in the White House or the EU).
- Market Structure (supply): central bank gold holdings have dwindled significantly over the past two decades due to the misguided competitive liquidation that they engaged their inventory in during the nineties when everyone thought that stocks and the USd were going to the moon. While such fads are temporary this one caused them to oversell their gold and depressed the market long enough to discourage any new investment in gold producing capital (the same story appears in oil and other commodities - all due to the machinations of monetary and currency policy during the Clinton-Rubin years - but it hasn't taken hold in gold yet like it has in oil because gold prices have been relatively tame so far). Thus the central banks are limited in what they can sell now due to depletion in inventory while the underinvestment in gold production has only begun to get rectified - holding it back has been the plain fact that foreign currency gold revenues haven't been keeping up with the inflation in the costs of production like the prices of commodities in the other mining sectors. Hence the market is still tight.
- The diminishing demand for the US dollar as a core central bank holding (or reserve asset) due to competition from the Euro, peaked confidence in the Fed (thanks to the tech boom that it ultimately could not sustain), and also in the private sector (particularly in countries that sell oil but also in others where the US dollar doesn't quite have the reputation Wall Street imagines) is a long term trend; we reckon it is the beginning of the end of its status as THE reserve currency, and that it is going to be a long term trend interrupted only on those occasions when other overly inflationary currencies blow up.
- Confidence in the Euro is premature and probably limited in scope anyway (due to the politics of the union and an entrenched interventionist philosophy); meanwhile a noticeable interest in a commodity reserve by some central banks has begun to surface (Islamic, Argentina, China - China is underweight in official holdings; if they were to increase their holdings to match the proportion of reserves that the European banks usually hold in gold, you don't even want to know what it would do to gold prices).
- Lack of sound money can only become more apparent in light of the progression of inflation policies.
- General overvaluation of stock and bond markets (paper) continues to diminish their attractiveness at the margin, and divert inflation plays into real values instead (i.e. commodities and real estate).
Ed Bugos
Editor - The GoldenBar Report
www.goldenbar.com
October 9, 2005
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