The Gold Conundrum

The combination of unusually contradictory economic signals plus political and social crosswinds have meant extraordinary volatility and confusion in debt and equity markets. Expectations and explanations for the action in gold are no exception. As the spot market rose to new highs today, September 14, disbelief appears extremely high. What is going on?

"Gold bugs" have always been derided. This has made it pretty hard for investors that are already involved or considering that section of the market to believe in their rationale, lest they have been unwittingly infected by "the bug" or considered part of the tinfoil hat crowd.

For the moment, let's set aside thoughts about Indian jewellery demand, absence of industrial use and the repeated view that it is a relic of an earlier order of international settlements that eventually outlived its reason for existence until the Nixon era. The first is too small to have anything other than seasonal effect; it's true, there really is no industrial demand on the horizon and the prospect of the IMF or other bodies adopting some widespread form of gold-related standard among nations appears unlikely any time soon. Then there is is the debate that we are more likely entering a deflationary period (declining aggregate prices) than an inflationary - even hyper-inflationary - one.

In this writer's view, at present the monetary issue is the key. Observations that the current environment has deflationary characteristics have supportable evidence, but a lot of it - not all - involves the rear-view mirror. The public perception of well-being typified by the seemingly permanent decline in Walmart pricing is ending as originating and transportation costs rise. US consumers are struggling with personal balance sheets by curbing consumption and paying down debts. For now, Canadians are busily going in the opposite direction, increasing their debt. The divergence will not be permanent.

Areas of future influence where governments have the least control, such as worldwide food prices, are much more inflationary than those such as interest rates that are under vigorous, ongoing government suppression. US rates and the value of the US dollar relative to other currencies are the most significant influencing factors in the gold price.

Since US rates are the lowest in the world (the Japanese yen is not a currency for international settlement), the US treasury bonds that must be sold to fund the US trade deficit, increasingly cannot be sold in sufficient quantity to foreigners. The shortfall in purchases therfore has to come from the US government itself. This puts it in the position of being both the seller and a buyer. The result affects the US government's own balance sheet. The combination of these policies, when extended over an unusually long period of time such as is the case today, comes with an unavoidable delayed cost. Due to the nature of its markets, gold is an erratic but inexorable measure of these effects, when measured in US dollars.

Historically the international mechanism compensating for these effects occurs through differences in interest rates between nations. Debtor nations, of which the US is by far the world's largest, will usually have the highest rates. The problem is that simultaneously, as issuer of a currency that in better times was accorded the status of reserve currency, meaning the one that all other settlements can be paid with, there is a huge conflict.

As a current core aspect of US government policy, the American interest rate shock absorber has been disabled. Throughout the exercise, official salesmanship says US policy is one of "maintaining a strong dollar." In the short term it is a situation with no political prospect of change. As a result, gold gradually and unofficially resumes the role of adjustment mechanism.

Notice that official US talk dismissing a rising gold price as meaningless, is completely consistent with its misleading "strong dollar" sales pitch. The key to the gold price conundrum is that for the remainder of this policy period - for whatever time it continues - the effect of these policies is the true driver of the gold price and the market is the enabler.

Of course in the world of global politics and international hegemony, it cannot be ignored that the US's single biggest creditor, China, has now become the world's largest gold producer. China is now putting in place its own policy of allowing gold to become a more important component of its currency policy. Part of this is being done by changing internal Chinese regulations to ecourage wider domestic investment in the metal but especially wider opportunity for Chinese citizens to invest in gold-related stocks.

Among these planned market vehicles, certain of them are identifiable as "dragon's head" national champions in which elements of the Chinese government itself has a stake. It will be interesting to see if this policy will induce some level of switch by investors to Chinese gold stocks from Chinese real estate. Not only are real estate prices viewed as unsustainable, but there have been calls for real estate prices to be moderated in the Chinese market for social reasons.

On the other hand, as well as providing a new investment alternative, such a directed capital reallocation should avoid pushing funds into and thereby exerting pressure on other domestic prices to feed inflation. For China, gold investment opportunities may achieve that goal.

At the same time, success for investors would increase the "wealth effect" for a growing middle class. This is needed to pick up slack in export demand and shifting it internally. In turn it also mitigates the otherwise negative effect from a trade standpoint from the resulting higher value that will take place in the Chinese yuan.

Such an increase in the relative value of the Chinese currency has been loudly demanded in US political circles for several years. China appears now in the process of putting this demand into effect as a change in its economic policy. I expect it could be evident by Q2 2011.

There is a saying, "watch what you wish for", because unintended consequences abound.

Disclosure: long CGG-T

Bummed Out by the Confusion

It's all been said endlessly, in newspapers, CNN, CNBC and the financial blogosphere - there has never been a time of such conflicting data and opinion. People are genuinely being turned off North American equity markets. The tone of US political bickering is discouraging and uninformative. Canadian politics seem designed to put the electorate to sleep and if they wake up, they shut the shop. Out of all this, people are advocating "throw them all out", which is understandable but seem at the same instant to embrace radical positions that if actually enacted, would worsen their own situations, which is not.

On top of this, we have cries of 'treasury bubble', 'gold bubble', scary Hindenburg Omens, what-if "W" scenarios, deflation-inducing de-leverage, closed-door credit, persistent unemployment, flatlined incomes, debt and pension crises, 'I'm OK so far' housing here, debacles elsewhere. No wonder equity investment is declining and people are easily stampeded into bonds at non-existent interest rates, just in the hope of preserving original capital. Theories abound for an imminent further drop in US markets. None, except for general contrarians, call for an advance.

The actions being talked up in America and Europe, if actually pursued to their conclusions will mean at least 2 or 3 years of considerable difficulty for most citizens. In Europe they are already in place. In the US they are not. I believe they will not be enacted there before the Nov. 11 elections and even less so afterwards, despite current claims to the contrary.

Many large corporations have quite decent balance sheets. But the US government, whose actions in conjunction with the US Federal Reserve affect us all, does not. Add to this state revenue shortfalls and the competition to sell bonds by governments to somebody that is NOT the government (unless its foreign), will be intense.

Most recent government financing has been into the short-term market. That means - as a certainty - that in order to raise new money, simultaneously all of the short-term debt has to be rolled over (re-sold) also.

We see that in the short term the economy will be weak and unemployment persistent, so tax revenues will be poor. The new debt numbers will therefore be monumental. If the debt is not sold - and the need will be such as to guarantee fierce competition - it is exceedingly unlikely that rates can be held down. The repeated periods before each major issue will seem like mini-crises.

This not irrational scenario will put huge pressures on North American and European currencies. Commodity sales will help Canada but our currency cannot get so far separated from the USD as to collapse our industrial sector.

Currency changes exist in relation to other things. The best of energy and gold stocks would survive. If as an alternative you want the most secure and liquid direct gold participation, I have previously suggested looking at the Sprott PHYS ETF of Canadian-held physical gold. It trades in USD. Don't switch currencies until you are ready.

Position: Long ARNA-Q, CGG-T, VET.UN-T

Confirmation of a View

With a stay in the hospital happening within a market period with plenty of weekly volatility but very little new substance behind it, I have been keeping up but not writing. Events make it time for another post.

A few weeks ago, everything focussed on the demise of Euro sovereign debt and a corresponding media barrage supporting future strength in the USD. While large US corporations and banks were (and are) doing fine and many manufacturers were finding an improved export edge due the previously lower dollar, nothing that the US government or the Fed had done suggested that they had changed their position of allowing the dollar follow its own course. That this course is downward has no connection with the permanent official line of support for "king dollar".

On Tues Aug 10, the message from the Fed Open Market Committee (FOMC) was that it was leaving rates alone. It did not mention deflation but stressed the economy was weak and indicators unusually mixed. This caused an immediate general selloff that swept across Asia overnight. Strangely to some of us, gold dropped in lockstep with the market. Since "everyone knew" that the Obama administration had been forced to stop anything resembling a further bailout or economic support - very dirty populist words - prior to the November 8 elections, it could make sense.

However, the real reason was because commentators had not looked closely enough at the Fed's additional statement that capital recoveries on their previous purchase of "toxic" mortgage debt (to save the real estate industry, mortgage holders and those in Congress up for re-election), the proceeds would be reinvested in US long Treasury bonds. Since all those mortgages could not be a total writeoff, the plan was that any capital recovery would drop off and reduce the debit side of the Treasury's balance sheet. A day later, markets grasped that this previous potential reduction would now be used to monetize new US Treasury debt. The semantics if not the theory being, no new money would be involved! The USD sank and gold recovered.

In a nutshell, this validates our position that there is insufficient political will in any currently visible US Administration to do what Europe at least officially stated it would do; that is, put hard decisions into actual effect to improve their sovereign debt positions. Of course by its very actions, the Fed has made it much more difficult for those that are trying to put their houses in order, to do so. The Canadian economy, which had been remarkably strong, started to look weaker as the BC and Ontario HST kicked in and manufacturers felt their prices rising in the US market as the US dollar fell. Recent hikes in Canadian interest rates only added to the discrepancy and make the timing look inappropriately hasty.

Our investment outlook is unchanged for the time being. We have re-expanded our long position in China Gold International Resources (CGG), formerly Jinshan Mines (JIN). We have also expanded our position in the well-managed and geographically diversified Vermilion Energy Trust (VET.UN), which will soon be converted to a normal corporation. There is a possibility that in due course Vermilion may seek to expand its listing (and therefore its market capital potential) to include the NY NASDAQ. We initiated a modest speculative position in Arena Pharmaceuticals (ARNA). The US FDA will review its unusually promising diet and weight control product, Locaserin, in mid-September.

Much has been made of a current gold bubble. There are vested interests who wish to maximize this view. It can be argued that a much larger bubble is occurring in long-dated (10 year is the bellweather) US federal, state and municipal debt. An eventual decline there will affect debt markets everywhere. Whether the Euro zone recovers will depend upon the ability of the weaker countries to govern in the months immediately ahead as the effect of tough policies bite pocketbooks and retirement.

I came on this jewel recently, written by Ambrose Brice circa 1880. Brice was an American essayist and social critic.

"... politics is a strife of interests masquerading as a contest of principles...the conduct of public affairs for private advantage."

When Did the Game Change?

Did you see that? A few days ago, Europe, the Euro and European sovereign debt problems were pulling markets down. Thank goodness the US was coming to the rescue with its strong dollar. But in a blink after the TV channels were were changed from the FIFA World Cup, we find that Europe looks OK, but the US is falling apart! Are you kidding? What happened over the weekend?

Like we said in an earlier post, the Euro was looking bad only when it was playing catchup in the downward currency slide already led by the US dollar. Suddenly, northern European competitiveness is looking vastly enhanced. Europe was apparently not only talking tough fiscally but looked like it might actually do something about it.

Rather inconveniently, figures confirmed that the typical American consumer is absolutely mired in a negative personal balance sheet disaster, but also that employment - already officially overstated - was plunging no matter what rosy spin was put on the numbers. The combination is utterly toxic and short of faith-based economics, is beyond structural fixing in the near term.

The European central banks are only charged with keeping inflation under control. The US Fed has the extra official burden of maintaining employment. Congress wants both but jobs talk loudest. What they say is 'this time is special, so roll the presses'. Did I mention that the US wants to wind down its military presence overseas but at the moment the are no extra jobs waiting, as was promised, for returnees?

That's one side of the dilemma. The other is that China now owns one-half of the US external debt and makes the stuff that US consumers want to spend their not so available money on. If money is relatively unavailable, that would make rates go up, right? Interest rates must be held down at home or the time bomb of external American interest payments will blow everything else it tries to do out of the water. Never mind entitlement expenditures. Interest rates are the 800-pound gorilla that's too scary to talk about.

We are now entering an end-game period when the curtain will be lifted on just how much the US dollar, the world's reserve currency, is going to have to be inflated to keep Americans working at the same time as it attempts to diminish the external value of American debt repayment. The Japanese have a huge debt to GDP ratio. The thing about Japanese debt is that, by far, most of it is owned in Japan. So, other people's currencies getting stronger; official reserve currency getting weaker. Expect international rhetoric and protests to get very strident and hope for nothing worse.

For the Fed to fix that one painlessly, the trick will be to shift the pain elsewhere. Elsewhere may not be happy at the prospect.

An Intellectual and Tactical Challenge

Financial and investment markets at mid 2010 have rarely presented an equivalent challenge.

The growing concensus in early May of a V-shaped recovery abruptly shattered by June against the morphing of the international crisis of housing and banking into a sovereign debt crisis. This materialized with the exposure of the unsustainability of southern European national finance and social policy through their negative impact on the Euro. The outcome briefly made it appear that the US dollar was inherently strong. But it soon became apparent that the effect was only one of relationships, during which the Euro's decline simply accelerated to catch up with a decline that had already occurred in the US dollar.

Muddied over by the ongoing news coverage of the gulf of Mexico ecological disaster, the dawning understanding that the US housing debacle's effect had not yet played out occurred just as the inability of the federal government to continue its monetary stimulus made the dreaded W-recovery (or double-dip) loom as the more likely outcome. US consumers appeared to be spending on current needs by ceasing mortgage payments on houses in which they had no equity and from which they were unlikely to be evicted. State and municipal tax revenues continue to plunge.

New financial regulations (the so-called FINREG bill) may become within the US are expected imminently. However, the investment community feels that as presently constructed, they will serve banking interests far more than consumer interests as originally proposed.

While that works its way along, there is the realization that the post-2008 monetary easing is for the first time occurring within a fully engaged and therefore essentially closed global system, which now needs to be priced into international debt and equity markets. During the leadup to the Toronto G20 meeting, increasing angst and ink was spent on the relationship between the US dollar, the Chinese yuan (RMB) and gold. Gold morphed from an inflation play to a fiat currency issue and reached new current (non inflation-adjusted) highs. Saudi Arabia disclosed a major proportionate increase in gold among its reserve holdings. Already the largest producer, China continued to lock up more non-Chinese gold properties throughout the world by commercial deals, at the same time stating it saw no reason to buy more on the open market, such as from the IMF. Its latest currency adjustment makes gold cheaper within the domestic market.

The slow decline policy of the yuan from its former US peg as newly revealed this past weekend will allow elasticity for consumer demand in the US and elsewhere to remain more intact than it would have been with the major one-off revision the US had pushed for. Since wages are rising in China and domestic demand there will be stimulated, any success of the revised Chinese export policy will mean the rest of the world will pay for the rise in the Chinese standard of living without being able to correct their own trade deficit issues. The sovereign debt issue will persist.

The relative rise in the dollar over the last month helped the US Treasury successfully sell more debt to income-starved investors around the world at ultra-low rates of return. As economic historian and Harvard professor Niall Ferguson stated in a CNBC interview today (June 21), a realization among investors is bound to arise - within 2 to 4 years at best, sooner at worst - that rates must rise. The outcome, when translated into the billowing aggregate global debt, will be that debt maintenance - let alone reduction - will have already moved beyond reach. If and when that day arrives, bond values will plunge as demand for higher yields force them down. The impact on many ordinary and institutional investors - especially the more conservative ones - will be disastrous.

The challenge right now is serious. Many mature investors will be hard pressed to survive with their lifestyle intact and with a recovery doubtful for them in a meaningful time frame, while most younger ones appear to be carelessly texting and tweeting into their financial fate. Collectively, it is not clear if the various national publics affected, from Greece to Britain and the US, will be willing to accept the necessary fiscal medicine as politically palatable, in view of the high economic price that, with hyperinflation the other option, needs to be paid.

Further Notes on Precious Metals ETFs

Last week I mentioned the US-dollar denominated Exchange-Traded Funds, the gold SPDR listed as GLD, whose custodian is JP Morgan, and the iShares silver ETF listed as SLV, whose custodian is HSBC Bank. As a cautionary note, these 2 banks are known as respectively among the largest gold and silver short traders in the market. This position is arguably not congruent with the interest of the investors purchasing these ETFs as investments in the metals themselves.

It has also been repeatedly noted that within the lengthy prospectuses of these two ETFs, important factors such as transparent disclosure concerning how much bullion is actually held and the changes in these holdings over time (they should be rising if net new investment is rising), is not disclosed by their prospectus and cannot be determined. As a result, though commonly recommended by many advisors, the shares should rightly be regarded as mere proxies for the metals, not certificates representing ownership of actual redeemable gold or silver. In a flash panic such as affected several ETFs recently or some other extreme event, knowing exactly what you own is important.

On the other hand, the recently-launched Canadian-managed (2010, by Sprott) US-denominated physical gold ETF listed as PHYS discloses its actual gold holdings, which are held and sequestered by the Bank of Canada. While its short market history and smaller comparative size make the shares of PHYS more thinly traded at present, for the more capital-protective and self-protective investor, the crucial aspect of actual ownership may be more important than its trading volume.

Disclosure: No positions

Currency, Sovereign Debt and the "Gold Bubble"

The following valuable perspective is acknowledged from the respected Calafia Beach Pundit blog of June 7, 2010. The issues of sovereign debt, currency movements and the inflation/deflation question are aspects of the economic machinery that the global gold price reflects in the present cycle stage we may come to call the Keynsian end-game.
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"The euro (as the extension of the DM) and the dollar have been moving pretty closely together relative to gold. That is to say, both have depreciated by almost the same amount since 1978, with the dollar for the most part leading the way. You might say the euro's current weakness is more in the nature of "catch up" to the dollar than anything else. Recently, the euro was trading at a nice premium to the dollar, but that premium is no longer justifiable given eurozone credit concerns and the bailout of Greece.

"The euro - relative to its purchasing power parity vis a vis the dollar - has not changed much at all since 1978. It was slightly overvalued then as it is now. In other words, relative to 1978, one euro today will buy you about the same basket of goods and services in Europe as it would in the US. So the message is that both the euro and the dollar have fallen by more or less the same amount relative to gold. The yen is the only currency that is worth more today, in terms of gold, that it was in 1980.

"Regardless, the movements of all major currencies relative to each other are now dwarfed by the movement of all currencies relative to gold. ...If gold is still the timeless standard against which to measure currrencies as it has been for centuries, then today it can be said that the relative valuation of one major currency relative to another is an order of magnitude less important than the relative valuation of all currencies relative to gold.

"If all major currencies are losing value relative to gold, that is a good sign that the world's supply of money exceeds the demand for it, and that is a necessary precursor to rising inflation. We should expect to see inflation rising in just about every country, and it ought to show up first in lesser-developed countries, since their economies are generally more exposed to international trade and have a lot less inflation "inertia" than the US economy.

"I continue to believe that it makes a lot more sense to worry about inflation than it does to worry about deflation, given the significant rise in gold over the past 10 years."
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For investors, physical gold can be held through the US ETF PHYS and more popularly but perhaps less securely in the US ETF GLD. Gold stocks on whatever market vary in quality from investment grade (primarily based on proven reserves) to speculative (unproven or proximity to proven reserves) but are generally seen as being more responsive (leveraged) to gold price movements than the metal itself.

Disclosure: long Jinshan Mines (JIN), soon to be renamed China Gold International Resources.