Sunday, June 30, 2013

Gold Driven By Financial Instability, Not Inflation

While I've talked about inflation adjusted targets for the Gold price, it is not my opinion that inflation or expectations of inflation have been the primary driver of the Gold market over the last half a decade. Since late 2008 the primary driver of the Gold bull market has been (fear of and policy reaction to) financial instability, this was a significant change from earlier years when the rise in Gold price remained inline with that of other commodities (whose prices increased with demand on the back of debt driven growth).

The change in drivers is well represented by the below chart which shows the Gold/CRB Index ratio:


In box 1 you can see that Gold's growth remained stable relative to that of the commodity complex. Box 2 shows that Gold has significantly outperformed commodities in the bull market phase since late 2008, clearly indicating a shift in what drives the Gold market.

While there isn't always a direct correlation (with the short term Gold price) the below chart showing the S&P 500 Volatility Index is an easy way to confirm that stock market volatility (one sign of financial instability) was at increased levels while Gold rose strongly over the late 2008 to late 2011 time frame (although Gold was initially liquidated along with others assets earlier in 2008):


The St Louis Fed Financial Stress Index shows similar:


The events resulting in financial instability have been varied in nature, from a banking system crisis & congress disagreements on the debt ceiling in the United States, to bailouts of Eurozone countries, to the meltdown of a Japanese nuclear plant. A majority of events causing the financial instability have been a result of excessive private or public debt and the the policy reaction to patch this up by shuffling the debt around (e.g. moving it to the balance sheet of central banks) or creating more (e.g. large government deficits to spur growth). Mostly these exercises seem like attempts to give extra life to a monetary/financial system and growth model which is clearly not sustainable.

The monetary easing over this volatile period increased the level of speculation in the Gold market, with quite a few hedge funds loading up on the shiny metal.

Since late 2011 volatility in the stock market has trended lower and prices have trended higher. The market hasn't been without regular corrections, but no crashes with the ferocity that we saw in 2009, 2010 & 2011:


The cyclical bull market in equities has kept investors complacent and it has drawn money away from (long) price speculation in the Gold market with the inventory of GLD falling off a cliff over the first half of the year:


The COMEX has also seen a large drop in the net long position of large, small and managed money speculators:


It seems inevitable to me that the complacency which has spread through global markets will eventually unravel. How or exactly when is not predictable, but with global growth slowing (even as central banks engage in stimulus measures):


And now with some central banks teasing at the possibility of 'tapering' stimulus, it seems likely we could be close.

The recent shock to China's financial system could be just a taste of what's to come:


And while mainstream Keynesian economists remain positive on Japan's outlook following unprecedented monetary stimulus to reinvigorate their economy, there are likely to be unintended consequences that arise as a result.

There are some signs that the capitulation last week could have marked a significant low or the bottom (long term readers of the blog will know that I was wrong with expectation of a bottom several months ago) and a few days does not make a trend, but the strength in Gold stocks is promising. Further more we appear to be in limbo land where many chart analysts are calling for lower prices and where it's already fallen lower than the expectation of many bulls (including myself), seems like a good place to turn and surprise everyone. Also, as I pointed out in a recent post, the price of the metal is falling below mining cost for many of the marginal producers, the mid 1970s correction in Gold bottomed soon after this occurred.

What will turn the price of Gold and Silver around? In my opinion it will be the return to financial instability as a result of reduced monetary easing measures or a shift in understanding once the market realises that quantitative easing is not going to lead to sustainable and natural economic growth. The price could also be turned around if the increased level of demand in the East continues to need excess supply from the West. Chinese Gold delivery via the Shanghai Gold Exchange is almost matching newly mined supply, if this demand remains strong and Gold stops being drained from inventories in the West (such as from GLD, COMEX) then we will likely see the price rise as a result:


When the price of Gold falls there are some who attack those who advocate holding Gold, but comments questioning Gold's role as a safety haven because the price is dropping miss the point entirely. Many of those advocating physical ownership of metal are not buying to profit, but as a form of insurance. What's at stake when we see financial instability is not only the risk of losing some money, but collapse of the entire financial system (something we came close to in 2008). If such an event were to occur, the exact outcomes would be unknown (and likely differ between countries), but holding tangible assets while this risk remains real is important. For this reason, anyone and everyone should hold some Gold.

The big question on everyone's minds, should I be buying Gold & Silver at these prices? Speculators should probably wait for the price to signal that it's ready to move higher, but the precious metals investor or saver should continue adding to positions inline with their strategy. Those with no position in the metals, should see current prices as a gift... their insurance premium (to hedge against collapse of the financial system or change to the monetary system) just got ridiculously cheap.

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3 comments:

  1. http://australianpropertyforum.com/topic/9908198/

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  2. If it wasn't clear, the article is referring to the last 5 years, so comparison to 1980 is irrelevant. Primary driver of the Gold market can change over time. However, the uncertainty around inflation & US Dollar was resolved with high interest rates by Volcker (IMO the huge rate increase, although a shock to borrowers, would have reduced the financial instability inflation was causing).

    The precious metals market is not transparent enough to confirm with any certainty what happened in 2008 (some say large US banks held positions that were being liquidated at the time), but it's a bit silly to look at the 30% drop without taking into account the huge rally seen later in 2008 and over the following 3 years.

    Neither Cyprus or China have caused financial instability to the degree we saw over 2008-2011 as measured by the Fed index.

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  3. Very interesting phenomenon! Worth taking account of, but I'll keep my eyes on factors that influence silver... I won't bet on the correlation, but it certainly is interesting.

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