Steve Saville wrote a post this week,
in which he proposed a model that indicates the fundamentals of gold. According
to him, these are: (1) the real interest rate, (2) the yield curve, (3) credit
spreads, (4) the relative strength of the banking sector, (5) the US dollar’s
exchange rate, (6) commodity prices, and (7) the bond/dollar ratio.
We consider him a friend, and certainly appreciate his view
that when gold moves from an ETF to China or India, it has no effect on the
price. However, we disagree with his fundamental model. Let’s do a quick
rundown of these factors and move on to a broader point.
1. The Real Interest Rate.
We have addressed
this before
, saying:
The Nominal Interest Rate means the rate at which lenders lend and
borrowers borrow in the market. The
Real
Interest Rate
is the Nominal
Interest Rate
– inflation.
Notice the switcheroo. The actual rate charged by actual lenders to actual
borrowers is dismissed as merely
nominal.
A fictitious rate which is not used in any transactions is elevated to the
status of
real. Got that?
This is on top of two other problems. We all learned in
grammar school that you cannot add apples and oranges, but economics unteaches
that and says you can average apples, oranges, gasoline, and rent. Except
economists don’t agree on which prices should be included.
There are many nonmonetary forces pushing up consumer
prices, such as taxes and minimum wages. Should one really try to adjust the
interest rate every time some economically-illiterate city council decides to
hike the minimum wages?
We have written before that there is sometimes a correlation
between (
nominal) interest and gold
prices, such as 1971 through 1980. Interest on the 10-year started January 1971
at 5.5% but by the end of 1980 hit 13.1%, or +138%. The price of gold started
1971 at $35, and hit $880 in 1980, or +2,329%.
However, there are also times of inverse correlation. In
2000, the price of gold started around $282 and hit around $1,900 in 2011. This
was a period of falling interest rates, down from 6% to 1.9%.
Depending on whose data you use, the real interest rate trends look similar to nominal, rising rapidly through most of the 1970’s and falling
after 1981.
Most importantly, how does interest drive the gold price.
And when we say how, we mean: what is the causal mechanism? We don’t see it
(nor, by the way, do we believe that any investment necessarily goes up when
government drives up costs and prices).
2. The Yield Curve.
This is a very important indicator. It drives many behaviors,
and consequently prices, in the economy. This is because when the yield curve
flattens, banks’ margins are squeezed. When it inverts, banks are making a
negative profit (i.e. loss) but still incur all the risks. Banks may be obliged
to sell assets and shrink their balance sheets. If they have a lot of gold,
then this could drive the price down. If not, then not.
The yield curve was inverted in the run up to 2008 as we see
in the graph below (and inversion lasted into 2009 on shorter maturities), and
there was a 30% drop in the price of gold.
We see periods of correlation, as the late 1980’s and
periods of anticorrelation, as 2012 through present.
It should be an interesting thing to watch now. As the Fed
has been pushing up the Fed Funds rate, the 10-year yield has been falling. It
seems likely to us that if the Fed persists on this impossible mission of
trying to hike rates then it will cause a yield curve inversion. If that
happens, something tells us that this time the gold price will not go down.
3. Credit Spreads.
We assume he means the premium paid by low-quality borrowers
above what the US Treasury pays. Like an inverted yield curve, rising spreads mean
pressure on the banks.
And like with curve inversion, it depends on how much gold
the banks and other leveraged players are holding.
4. Relative Banking Sector
Strength.
We haven’t plotted it, but we assume bank stocks will
outperform the broader stock market when the yield curve is steeping by way of
falling Fed Funds rate. This is when the banks’ net interest margin is rising,
and they are getting capital gains on their bond portfolio too. At the same
time, credit spreads are narrowing, so the banks are getting capital gains on
their junk bonds.
5. The US Dollar Index.
The way the world is supposed to work, according to the
Treasury, is every day banks and corporations are supposed to borrow
incrementally more, to buy commodities (i.e. inflation), speculative assets
(i.e. the wealth effect), and to hire people and expand business (i.e. growth).
Many of these speculative assets and businesses, are in other countries so the
other currencies go up.
There is an additional bonus for all the dollar borrowers
around the world. When their local currencies are rising, repaying dollar loans
becomes easier for them. So there is less default risk and the credit system
preserves the appearance of soundness for another day.
There are times when this is bearish for the price of gold.
After all, who needs a hedge against the financial system when it’s working as
it’s supposed to do. And there are other times, when the price of gold rises.
Such as 2009-2011, because of fears of
inflation.
We are hard-pressed to find much correlation though we see
one notable anticorrelation from around 1975-1978.
6. Commodity Prices.
This assumes that the price of gold goes up with inflation. At least raw commodity prices
are a better measure than consumer prices, which are more subject to more
nonmonetary forces.
There is a popular belief—I saw it expressed as recently as
Wednesday in my talk on the
MM
GOFO™
in London—that prices in gold terms are constant, a popular example
being that Roman Senators paid the same amount of gold for a toga as a modern
man pays for a high-end suit. Therefore by definition, if not by causal
mechanism, if the prices of commodities are rising then so too must the price
of gold.
For the truth, we encourage everyone to browse Priced In Gold.
To put this in perspective, the price has ranged below 1
gram per barrel to about 4.6g. That is a difference of 460% within an 8-year
period.
7. The Bond / Dollar Ratio.
This will go up with falling interest rates and rising
currencies. We have said our piece, above.
He states his premise, “gold’s true fundamentals are
measures of confidence in the Fed and/or the US economy.”
It is far from clear to us that the price of gold is
predominantly driven by confidence in the US. At times, for sure, but sometimes
not. We would restate the above premise as “sometimes, the marginal gold market
participants are those who worry about the US government / economy / dollar.”
Contrast that with the Monetary Metals fundamental
indicator. We are not trying to find proxies for gold demand, nor factors that
have correlated. We are measuring gold abundance and scarcity as they exist
right now, in the market.
How do we do that? We carefully measure the effect of the
speculators who use leverage to buy futures, and back this out of the price.
What is left is the price at which metal would clear today. Would clear, if it
wasn’t going into, or coming out, of carry trades.
This week, the price of gold was up three bucks, and that of
silver 2 cents. The gold-silver ratio fell a smidge.
As always, we are interested in the fundamentals. And by
fundamentals, we mean supply and demand conditions measured in the market. But
first charts of their prices and the gold-silver ratio.
Next, this is a graph of the gold price measured in silver,
otherwise known as the gold to silver ratio.
In this graph, we show
both bid and offer prices. If you were to sell gold on the bid and buy silver
at the ask, that is the lower bid price. Conversely, if you sold silver on the
bid and bought gold at the offer, that is the higher offer price.
For each metal, we
will look at a graph of the basis and cobasis overlaid with the price of the
dollar in terms of the respective metal. It will make it easier to provide
brief commentary. The dollar will be represented in green, the basis in blue
and cobasis in red.
Here is the gold graph.
We had a slightly falling price of the dollar (the mirror
image of the rising price of gold). The abundance rose (the basis) and the
scarcity decreased (the cobasis). All by small amounts.
Our gold fundamental price fell about $7 (chart
here
).
Now let’s look at silver.
The near contract shows a decrease in abundance and increase
in scarcity, but the
continuous
shows the opposite.
Our silver fundamental price decreased $0.22 (chart
here
).
|
Keith Weiner is CEO of Monetary Metals, a precious metals fund company in Scottsdale, Arizona. He is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. He is founder of DiamondWare, a software company sold to Nortel in 2008, and he currently serves as president of the Gold Standard Institute USA.
Weiner attended university at Rensselaer Polytechnic Institute, and earned his PhD at the New Austrian School of Economics. He blogs about gold and the dollar, and his articles appear on Zero Hedge, Kitco, and other leading sites. As a leading authority and advocate for rational monetary policy, he has appeared on financial television, The Peter Schiff Show and as a speaker at FreedomFest. He lives with his wife near Phoenix, Arizona.
|
The author is not affiliated with, endorsed or sponsored by Sprott Money Ltd. The views and opinions expressed in this material are those of the author or guest speaker, are subject to change and may not necessarily reflect the opinions of Sprott Money Ltd. Sprott Money does not guarantee the accuracy, completeness, timeliness and reliability of the information or any results from its use.
