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Whilst many
may argue that gold is an inflation hedge and therefore inflation is bullish
for gold, in reality the dynamics at play here are not that simple.
In our view,
gold is a currency. Therefore fluctuations in its price are largely based on
its perceived value relative to other currencies. We would not suggest that
its role as an inflation hedge is a primary reason for being long gold, since
there are far more direct and efficient ways to hedge against inflation risk
in this modern financial environment. We do however see currency devaluation
as a primary reason to own gold. If one thought the Yen was going to
strengthen against the dollar, then one would move USD holdings into JPY. If
one thought the Yen was going to weaken against sterling, then one move JPY
holdings into GBP. This environment is unique as across the world governments
and central banks are trying to lower the value of their currencies. Therefore
there is nowhere to go, except for gold which cannot be printed in an attempt
to erode its value.
The US
Federal Reserve has a dual mandate to both maintain price stability and full
employment. This means their job is to prevent deflation
and keep inflation in a tolerable range, plus ensure that unemployment
is not too high.
Clearly the
employment side of this mandate is not being met at present, with the latest
US payroll data showing unemployment still at 9%. However the one thing
holding the Fed back from further easing is inflation. We can therefore
deduce that a drop in inflation would be very bullish for gold prices, as it
would increase market expectations of more large scale asset purchases
(LSAPs) by the Federal Reserve.
Consequently
a drop in CPI inflation would be the most bullish signal for gold that we
could think of. A large increase in unemployment may also push the Fed to
ease, but disinflation would carry more weight as the Fed is then failing on
both its mandates. In our opinion the Fed fears deflation more than high
unemployment. Whilst 9% unemployment is a situation that nobody wants,
deflation carries far greater risks as it could lead to a deflationary spiral
and depression. However persistently high unemployment is adding pressure for
the Fed to ease and soon that pressure will become so large that the Fed has
to ease. Nonetheless a drop in the inflation rate would massively increase
market expectations for further easing, and therefore be tremendously bullish
for gold prices.
We do not
think any further easing from the Fed is due until 2012, but do think long
positions in gold are warranted at this time as there is a significant chance
that the market will begin increasing its expectations of easing over the
coming months and therefore would drag gold prices higher.
US Real
Interest Rates and Gold
In our
opinion one of the main determinants of gold prices in the medium to long
term is US real interest rates. US real rates are the rate of interest that
can be earned on US Government bonds, minus the expected rate of inflation.
One can monitor US real rates by watching the yields on Treasury Inflation
Protected Securities (TIPS) and we watch them closely since they exhibit a
negative relationship with gold.
The basic
fundamentals behind this inverse relationship are that when US monetary
policy is looser, real rates fall and therefore investors buy gold for a
number of reasons which we have covered in previous
articles.
Currently
when we analyse where US real rates are in relation
to gold prices, we come to the conclusion that gold prices are low in
relation to US real rates.
Our model for
analysing the relationship between gold and real
interest rates suggest that gold prices should be significantly higher than
$1800.00/oz, given the current level of US real
interest rates. Of course no model is perfect and even if it was it
doesn’t mean that gold prices must rise, as real interest rates could
increase and the relationship would remain intact. However if the US does
embark on further monetary easing, or market expectations of easing increase
then US real interest rates could fall still further, implying an even higher
gold price.
Eurozone
During the
last month, stocks and most other risk assets have rallied significantly. Fears
over Europe have subsided somewhat and the many parts of the market indicated
a brighter future ahead. Although there are many positive signs, we think
there are some seriously negative signs coming from the European sovereign
debt market.
These troubling
signs are in Italy and in Spain and should not go unnoticed and are much more
significant that Greece. For example the estimated cost to Germany of bailing
out Greece, Ireland and Portugal entirely in the wake of the default of those
countries would be a little over EUR1,000 per
person, in a single hit. Italy is a totally different situation,
their mountains of debt dwarf that of the smaller nations.
Since the end
of September Italian and Spanish yields have been moving higher, despite the
ECB bond buying programme in an attempt to keep a
lid on interest rates. This week we saw the ECB cut interest rates by 25bps
but not only did that not solve the problem, it actually revealed (or perhaps
confirmed) an even larger problem.
Italian
Government 5 Year bonds were trading at the beginning of this week around
5.73%. Just before the ECB unexpectedly cut interest rates by 25bps, the
bonds were trading at 6.13% and then fell to 5.82%, which is a drop of 31bps.
However these levels could not be held and the bonds sold off to 6.19% once
the initially rate cut induced buying had subsided.
This is a
cause for concern as it implies that Italian Government debt is no longer an
interest rate instrument, but more of a credit based instrument. This means
that the ECB can no longer help Italy with interest rate cuts, because no
amount of cuts of short term lending rates can remove the real credit risk
that accompanies Italian debt. Interest rate cuts may help countries such as
Germany and France as their government bonds still trade in line with
interest rate expectations, but it is not helpful for Italy any more.
We witnessed a
similar scenario with Greece, Portugal and Ireland. When the credit risk is
the driving factor behind the market, fluctuations in short term interest
rates have little impact. Whilst they may work for nations like Germany, that
doesn’t really help the situation as Germany does not have a debt
problem and the yield on 2 year German government bonds is only 0.4% at
present.
So what can
the ECB do?
Now that
Italy is immune to interest rate cuts, the ECB has very few options. It can
step back and leave the politicians to deal with the crisis, but we doubt
that this course of action has much
chance of a happy ending. We
seriously doubt the capacity for Italy to form, pass and implement a credible
austerity plan that would calm the markets and lower yields. Recently Italy
announced that they had a plan to make a plan to tackle the issue, which
consisted of increasing the retirement age by two years by the year 2026 and
raising a measly €5 billion from privatisations.
This calibre of plan is not even close to being
acceptable by the markets.
Therefore we
think the ECB has little choice but to directly intervene in the Italian debt
markets as they did in early August. If the new (Italian) head of the ECB
really wants to get a control of this situation before it gets out of hand
then the announcement of large scale purchases of Italian debt appears to be
the only credible option. There is little benefit from cutting interest rates
again from here. Direct intervention and large scale asset purchases by the
ECB will need to come from printing more Euros, a form of monetary easing
that is bullish for gold prices.
Sophisticated
investors may wish to consider being long gold and short Italian government
bonds. If the ECB turns on the printing presses to stop Italy falling off a
cliff, then gold prices will benefit massively. However in all likelihood the
best the ECB could do would be to cap yields, they can’t drive yields
into the floor as the underlying credit issues are still there. If they
don’t print to save Italy, then it is likely that Italian government
bond yields will continue to rise and thus a short position is warranted. Gold
should remain supported under this scenario due to safe haven buying. We feel
this is a compelling pair trade.
This could be
done directly via physical or futures, or even via ETNs with short positions
in ITLT (PowerShares DB 3x Italian Treasury Bond Futures
ETN) or ITLY (PowerShares DB Italian Treasury Bond
Futures ETN) paired with long positions in GLD or DGP.
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