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I can remember only
one other time when market factors lined up as favorably for gold as they do
now and that was in the spring of 2008. There are a great many similarities
to gold market dynamics between now and then, but there are also great
differences. One of those differences is the huge influx of interest from
institutional investors led by hedge funds and big banks. In 2008,
institutional interest was light.
Now HSBC, JP Morgan
Chase, Bank of America Merrill Lynch, ABN Amro, UBS and Deutsche Bank, PIMCO
and Black Rock head a growing list of investment houses that view gold
favorably. In what could turn out to be the first among many such
announcements, Munich Re, the giant German reinsurer, said it was adding gold
to its reserves in the face of negative interest rates. Chief Executive
Nikolaus von Bomhard told a news conference, “We are just trying it out, but
you can see how serious the situation is."
As we move into the second quarter of 2016, It is becoming
increasingly clear that we are experiencing a tale of two gold markets. The one that
ended December, 2015 and the one that began January, 2016 – the choppy market
action visible on the near term gold chart and the trap door drops on the
longer term chart.* Clearly, there was no opposition to the shorts in the
paper market prior to January. Gold for the big banks and trading
houses was a one-way trade.
Then the psychology at the zero-bound began to exert
itself in the financial markets globally.
Goldman Sachs has been every bit the naysayer on gold, but it finds itself
pretty much a lonely bear. Gold’s choppy upward channel suggests that
the bank and hedge fund bulls (and some other big traders) are taking
positions on the other side of the market from Goldman. Still others
are covering shorts. The battle lines, it seems, are drawn. The bulls for the
moment have the ascendancy – all of which prompted me to dust-off an old jpeg
some of you might recognize from days past (the golden bull, top of the
page).
 
Now comes the stirrings of a new financial crisis. Japan
and much of Europe have already adopted negative rates. As for the United
States, in a speech before the Economic Club of New York Janet Yellen
explained (as reported by Financial Times) that "the Fed had little
scope to reverse course and stimulate the economy with rate cuts if the U.S.
hit the buffers, underlying the need for a gradual tightening of policy. She
homed in on risks still brewing in China and the oil market. . . ."
In other words, the Fed seemed prepared in December to
start a fire in order to give itself the ability to some day put one out. And
start a fire they did. The intense negative reaction on the part of emerging
countries and global financial markets was enough to force the Fed into a
hasty, poorly organized retreat. Out of sheer necessity, and in order to
restore some semblance of order in global stock markets, it decided to
maintain the status quo. In February, a chastened Janet Yellen testified at a
Congressional hearing that the Fed was taking a look at negative rates.
Some strong advice for central banks and funds
from the World Gold Council
The usually staid World Gold Council recently gave some
strong advice on gold and very low to negative interest rates to global
investors including central banks.
"We have entered a new and unprecedented phase in
monetary policy. Central banks in Europe and Japan have now implemented
Negative Interest Rate Policies (NIRP). The long term effects of these
policies are unknown, but we see discouraging side effects: unstable asset
price inflation, swelling balance sheets and currency wars to name a few.
Amid higher market uncertainty, the price of gold is up by 16% year-to-date –
in part due to NIRP. History
shows that, in periods of low rates gold returns are typically more than
double their long-term average.
Looking forward, government bonds are likely to have
limited upside, due to their low-to-negative yields and, in our view, would
be less effective than gold in mitigating risk, ensuring portfolio
diversification, and helping investors achieve their long-term investment
objectives. Portfolio analysis suggests that gold allocations in a low rate environment should be more
than twice their long term average. We believe that, over the
long run, NIRP may result in structurally higher demand for gold from central
banks and investors alike."
The fact of the matter is that there is not enough gold in
size available to accommodate a doubling of already strong central bank
demand. At current prices, the availability of metal comes nowhere near
matching the availability of capital. China, for example, is hoping against
hope that it will have enough time to beef up its holdings sufficiently
before the eventuality of a full-blown currency crisis. Barring a miracle on
the supply side of the fundamentals ledger, the likelihood is that they will
come up short.
This is a case where, for once, the
private investor has the advantage. Individuals can still buy gold and silver
in sufficient quantity to achieve their portfolio goals (and quickly if so
required). What we do not know is how long under the circumstances that
advantage will remain on the table.
* A note on price discovery in the
paper gold market: Anyone who has spent time studying the gold market
ultimately comes to the conclusion that the price is not determined in the
physical market, but in London and New York's paper trade. Though physical
trades are often hedged in the paper market, that activity makes up a very
small portion of the overall volume. As a result, the effects of movements in
the physical supply and demand on the price are indirect and often
misunderstood. Sooner or later though, the trends in the physical market do
manifest themselves in the paper market. That effect though is largely
psychological and, by saying that, I do not mean to diminish in any way
it importance. The profound change in sentiment resulting from the low to
negative interest rate environment is an example of this principle in action.
Banks and hedge funds, unlike private,
individual investors, trade at the commodity exchanges and ETFs when they
take positions in the gold market. In the aggregate they bring substantial
capital to the table – enough purchasing power to move the market in either
direction. The important takeaway in a nutshell is that strong physical
demand and the anticipation of future physical demand changed the psychology
in the paper market at the start of the year. It attracted significant
capital to the long side and pushed the price higher.
New physical demand will come on top of
already elevated base
(Why 2016 is different from 2008)
Any new gold and silver physical demand entering the
market relative to the interest rate environment will come on top of an
already elevated base. That base was built in the period after the Lehman
Brothers collapse and the big numbers never receded. Here for quick reference
is an overview of the sources of that demand, its importance to the overall
market, and the differences imposed on the market since the earlier
breakdown. Worth noting: Insofar as their demand is for the actual physical
metal, these three sectors will be in direct competition with each other.
• First, as pointed out in the previous issue of this
letter, central banks, led by China and Russia, are already aggressive net
buyers of gold. In 2008, they were still net sellers. "Central
banks," says the World Gold Council, "have been accelerating the
use of gold to diversify their reserves since the 2008-2009 financial crisis.
In the second half of 2015 alone, central banks bought more than 336 tonnes
of gold – the largest semi-annual total on record. The acceleration of such
purchases, across a diverse range of countries, highlights the fact that
diversification of foreign reserves remains a top priority for central banks.
As foreign reserve managers all over the world continue to grapple with the
challenges of negative nominal interest rates, we expect to see record
amounts of central bank gold purchases in 2016 (and beyond)."
• Second, private investor volumes globally are
considerably higher now than they were in 2008. In the years following the
initial phase of the crisis, volumes for gold bullion coins went multiples
pre-crisis levels and stayed there indicating the public concern about
central banks ability to deal with the crisis and any further escalation.
Investors need to take into account he potential for intermittent
bottlenecks, outright shortages and escalating premiums on gold and silver
coins and bars.
• Third, institutional investors, as covered in detail
above, have returned to the gold market, and as a result volumes at gold ETFs
are running at a record pace." Even though the ETFs for all intents and
purposes are a paper position as far as most holders are concerned, these
institutions must actually go out and procure the metal represented by sales
of shares. I would not be surprised to learn of record volumes at both gold
and silver ETFs now and as we move deeper into 2016.
Speculation on secret Shanghai Accord
“The dollar has taken a surprisingly big stumble in recent
weeks, prompting traders to ask: What’s really driving the selloff? The
answer some are coming up with smacks of conspiracy theory. Rumors are
flourishing that global policy makers made a secret deal at the G20 meeting
in Shanghai late last month. This ‘Shanghai Accord’ to weaken the greenback
was aimed at calming the financial markets, which had gotten off to an awful
start to the new year, according to the chatter." – Sarah Sjolin, CBS
MarketWatch
A G20 organized and implemented de facto dollar devaluation
would explain the “mysterious” dovishness at the most recent Fed meeting, and
subsequently Fed chair Janet Yellen's dovish tilt in a speech before the
Economic Club of New York. It would also explain gold’s surprise rise –
up 18% since the turn of the year. (See gold/dollar index overlay chart
immediately below) Much of that rise, driven by bank trading desks,
could well have been the result of leaks of the agreement.
If an accord has been reached, it bodes well for gold and
silver as we move deeper into 2016. Worth Wray, chief economist and global
macro strategist at STA Management and an expert on emerging markets, says
such an accord would be a game changer. "No foreign-exchange pact,"
she says, "was announced at the February meeting of central bankers and
policy makers from the 20 largest economies. That hasn’t stopped speculation
that a plan of action was whipped up behind closed doors, as its supposed
effects are beginning to emerge now: The greenback DXY has shaved off more
than 3% since the gathering, sparking a rally in stocks, emerging markets
assets and commodities.”
Rothschild - ". . .[W]e may very well be
in the eye of the storm."
“In my half-yearly
statement I sounded a note of caution, ending up by writing that ‘the climate
is one where the wind may well not be behind us’; indeed we became
increasingly concerned about global equity markets during the last quarter of
2015, reducing our exposure to equities as the economic outlook darkened and
many companies reported disappointing earnings. Meanwhile central banks’
policy makers became more pessimistic in their economic forecasts for,
despite unprecedented monetary stimulus, growth remained anaemic. Not
surprisingly, market conditions have deteriorated further. So much so that
the wind is certainly not behind us; indeed we may well be in the eye of a
storm.” – Lord Jacob Rothschild, RIT Capital Partners (2015 Year End Report)
The Bank for
International Settlements, the central bank for central banks, issues a
similar warning today rating the storm as “gathering” not fully imposed as
Rothschild grades it. “The tension between the markets’ tranquillity
and the underlying economic vulnerabilities had to be resolved at some point.
In the recent quarter, we may have been witnessing the beginning of its
resolution,” says Claudio Borio, the organization’s head. The word
“turbulence” appears 17 times in the report ( I counted them). Please see “Uneasy calm gives way to turbulence
.”
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