Since the July lows we have witnessed gold rocket northward first through the $1,000 per ounce mark and then the $1,100 per ounce mark, hitting an all-time high of $1,152.85 today. The move in gold off the July lows led to a more than 25% gain in the yellow metal with silver putting in an even more impressive move of more than a 42% rise. Clearly precious metals have been on a tear lately and there are perhaps several reasons for this that are all contributing to strength in precious metals.
The path of gold in 2008 was quite interesting as at times it moved inversely with the USD as is its normal relationship, and at other times it moved in step with the USD, contrary to the norm. Last year was truly a volatile year with many market participants never witnessing the market extremes such as we saw; the S&P 500 crashing, gold soaring and the entire financial system was on the brink of collapsing. Given the dramatic swings in the financial markets last year, it appears that the price of gold was being driven by different elements at different times. In the beginning of 2008 gold was benefiting from rising inflation and a weak USD while near the end of the year we saw the inflation rate via the Consumer Price Index (CPI) collapse and the USD rally strongly; and yet gold assaulted the $1,000 mark as it headed into this year. What gives?
The various interplays between gold and market variables is shown below, highlighting the link between gold and inflation (CPI), gold and fears of US creditworthiness (5-Yr UST Credit Default Swaps (CDS)), and gold and the USD Index. As mentioned previously, the first half of 2008 saw gold rise in concert with a rising inflation rate and falling USD. However, as the USD Index was putting in a bottom gold began to top with the inflation rate peaking soon after. However, in November of 2008 gold bottomed and yet the USD Index was still in an uptrend and the inflation rate was plummeting dramatically. What began to significantly rise in the last half of 2008 was the euro-denominated CDS on 5-Yr UST notes (second panel below) as the US government was bailing this and that agency or corporation out and the Fed ballooned its balance sheet. What appears to have happened was that foreigners were beginning to question the soundness of US debt given the bailouts and Fed balance sheet as reflected in a rising CDS on 5-Yr UST debt, with foreigners more willing to buy credit protection on US debt and likely also hedging their holdings with gold.
However, when the market bottomed and signs of “green shoots” began to spring in March of this year, fears of US creditworthiness began to subside with the CDS on 5-Yr UST notes falling back to November 2008 levels, and yet gold did not sell off. What also peaked in concert with the CDS on 5-Yr UST was the USD Index (third panel above), and a weak USD is positive for gold. Some may be confused as to why gold virtually traded sideways for most of 2009 while the USD Index experienced a significant decline. Actually, when taken into historical context, the fact that gold didn’t sell off even with a weak USD was quite remarkable.
For example, since the 1970s the common theme for gold prices is to peak near the end of a recession and then fall thereafter as investor’s shun the perceived safety of gold for stocks as investor spirits about the stock market and economy revive. There was an anomaly after the end of the 2001 recession as gold continued to rise, and we appear to be witnessing yet another deviation from the post 1970 script as gold has continued to remain strong despite a monstrous stock market rally. What was characteristic in 2001 that likely led to strong gold prices even after the recession is the same today, which is a HIGHLY accommodative Fed via a very low interest rate environment.
Source: www.kitco.com
The sustained low interest rate environment from 2001 to 2004 saw gold rise from a low of 3.85 an ounce to a high of 6.89 for roughly an 80% gain while the USD Index slid 33.6% over the same time frame. When Fed Chairman Mr. Bernanke did not change the wording at the November 4th, 2009 FOMC meeting that the Fed will keep rates low for a sustained period of time, gold vaulted even higher and was soon over the ,100 mark.
As early as August of this year the futures market was pricing in a 100% probability that the Federal Funds (FF) rate would be north of 1% by the June 2010 meeting. However, with the Fed Chairman’s remarks over the last several FOMC meetings regarding a prolonged low interest rate environment, the probability for the FF rate in June 2010 being below 1% began to rise, with the marking now pricing in only a 1% probability for a June 2010 FF rate above of 1%.
Source: Bloomberg
When looking at the futures market for the FF rate for November of 2010, heading into October of this year the market was pricing in a 90% probability for the FF rate to be north of 1%, with the probability for a 1% or greater rate by November 2010 plummeting after the November 4th, 2009 meeting. As of yesterday (11/17/09), the market was only pricing in a 13.4% probability of a FF rate of 1% or more and an 86.6% probability that we will see a the FF rate below 1% by late 2010. In fact, looking at the FF futures curve, the market is betting that we will not see interest rates north of 1% until 2011 and not above the 2% level until 2012!
Source: Bloomberg
Source: Bloomberg
Even the futures market may be too optimistic as Federal Reserve Bank of St. Louis President James Bullard said that Fed may not increase rates at all until 2012!
Fed May Not Increase Rates Until 2012, Bullard Says
Nov. 18 (Bloomberg) -- Federal Reserve Bank of St. Louis President James Bullard said past experience suggests policy makers may not start to raise interest rates until early 2012, while concern borrowing costs have stayed “too low for too long” may prompt an earlier move.
"If you look at the last two recessions, in each case the FOMC waited two and a half to three years before we started our tightening campaign,” Bullard said today in a speech in St. Louis. "If we took that as a benchmark, that would put us in the first half of 2012."
Bullard added that in the debate on when to tighten policy, "the idea that you might be creating asset bubbles by keeping rates too low for too long will be an important argument."
Policy makers after a Nov. 3-4 meeting repeated that they will keep interest rates near zero for "an extended period" while saying policy will stay unchanged as long as inflation expectations are stable and unemployment fails to decline.
The Taylor Rule, which provides a recommendation for short-term interest rates based on the interplay between inflation (CPI) and economic stability (unemployment rate), is likely being viewed by the Fed as support for their low interest rate environment. Historically, the actual FF rate has tracked closely the Taylor Rule estimate until recently, as the current Taylor Rule estimate says the Fed should have a NEGATIVE 8.45% rate given the current high unemployment and low inflation environment. The spread between the FF rate and the Taylor Estimate is at the highest level in a decade, with the standard deviation coming in at 3.94. To put that statistical number into context, readings greater than 3.94 standard deviations should be seen only 0.0041% of the time, or to put it differently, only once every 24,390 days or once every 66.8 years!
Source: Bloomberg
Source: Bloomberg
Given the extremely accommodative monetary stimulus of the Fed via record low interest rates, given the expected record fiscal trillion dollar deficits, and given that 2010 is an election year where the White House is likely to put pressure on the Fed to keep rates low given high unemployment, is it any wonder that gold and precious metal stocks are doing so well?
While the US may be fine with running the twin stimulus engines (monetary AND fiscal policy) jet engines at full throttle, it is not likely that our foreign neighbors will be as sanguine as the following article highlights.
China questions costs of U.S. healthcare reform
Guess what? It turns out the Chinese are kind of curious about how President Barack Obama’s healthcare reform plans would impact America’s huge fiscal deficit. Government officials are using his Asian trip as an opportunity to ask the White House questions. Detailed questions.
Boilerplate assurances that America won’t default on its debt or inflate the shortfall away are apparently not cutting it. Nor should they, when one owns nearly trillion in assets denominated in the currency of a country about to double its national debt over the next decade.
Nothing happening in Washington today should give Beijing any comfort or confidence about what may happen tomorrow. Healthcare reform was originally promoted as a way to “bend the curve” on escalating entitlement costs, the major part of which is financing Medicare and Medicaid. That is looking more and more like an overpromised deliverable.
We have heard throughout the year China’s concern about the USD and it appears that China isn’t the only country as foreigners are not only talking the talk, but walking the walk. While foreigners have still been buying UST debt, they are doing so at a slower pace than in the past and have also shifted their risk appetites as they have been buying less risky shorter-term T-bills as opposed to longer duration UST bonds. This shift may be the first step out of the USD as foreigners do not have to dump their UST debt in the open market, but rather simply let their debt mature and not rollover the debt repayments by the US Treasury into new debt.
Source: U.S. Treasury Department: Treasury International Capital Reporting System
Foreign UST Composition: Percent of Total Holdings
Source: Bloomberg
In concert with a declining appetite for USD-denominated assets, foreign central banks have stepped up their purchases of gold over the last several months. While most know of the recent purchase by India of 200 metric tons of gold from the IMF (India Buys IMF Gold to Boost Reserves as Dollar Drops) for .7B, some might not have heard this weak that even smaller countries are buying gold as the African nation of Mauritius buys 2 metric tons of gold from the IMF. This trend may continue as BlackRock, one of the world’s largest fund managers foresees central banks diversify away from the USD.
BlackRock says c.banks to be net buyers of gold
SYDNEY (Reuters) - Central banks will be net buyers of gold this year as they diversify away from the U.S. dollar, marking a reversal of a decades-old trend, global commodities investment fund BlackRock said on Monday in comments that helped drive bullion to fresh record highs.
Investment in gold by central banks has picked up recently, with India buying 200 metric tons from the International Monetary Fund, and Taiwan's central bank is studying whether to raise the amount of gold in its forex reserves, with China and South Korea also debating the issue…
Evy Hambro, who runs two of the world's largest commodities funds, BlackRock World Mining Fund and Gold & General Fund, gave an upbeat outlook for gold during a media briefing in Australia.
His forecast for net central-bank purchases of gold this year would, if met, mark the first year in two decades when the world's central banks bought more gold than they sold. They have been net sellers each year since 1988.
Gold stored in central banks worldwide has dropped more than one-sixth since 1989.
"The most recent break-out in the gold price in U.S. dollars has caused most gold prices to start trending higher at the same time," Hambro said, adding that investors were now looking for gold to rise in other commodities as well as U.S. dollars.
"When you start to see the price rising in a range of different currencies, it is a clear sign of a very strong market to come," he added…
"Gold's role is gathering a lot more attention in terms of risk diversification," he said.
By 1999 central bank selling was so commonplace that the big European banks signed a pact capping sales at 400 metric tons a year to keep the price from collapsing.
It worked. Gold has gone up just about every year since.
Hambro also said the high level of gold production in China, which has replaced South Africa as the world's biggest producer, was not sustainable, pressuring world supply.
China's output rose 13.49 percent in the first half of 2009 from a year earlier to 146.505 metric tons, according to the Ministry of Industry and Information Technology.
China is widely assumed to be buying domestic gold production after revealing in April it held 1,054 metric tons of gold, a jump of 76 percent from its last word on the subject six years earlier.
Given the strong demand for gold and given extremely stimulatory fiscal and monetary policy in the US, investment guru Marc Faber said recently that the price of gold will not fall below ,000 an ounce again, and a week later Mr. Faber said that the "sky will be the limit" for gold prices.
- Bloomberg News: Gold Price Won’t Drop Below ,000 an Ounce Again, Faber Says (11/11/09)
- Bloomberg Video: Faber Says 'Sky Will Be The Limit' for Rising Gold Price (11/18/09)
Once institutional and retail investors turn their eyes to gold the price movement of gold and silver stocks may explode for the simple reason as Casey Research puts it in the title to their November 2009 Casey’s Gold & Resource Report, “How will Niagara Falls Fit Through A Garden Hose?” While the returns for the AMEX Gold Bugs Index (HUI) have been phenomenal with a more than 180% rise since the lows of October of 2008, the best may be ahead for gold stocks once investors jump on the band wagon as it will be a bottle neck to buy gold and silver stocks given the small size of the industry compared to others. Casey Research visualizes this in the graphic below that shows how tiny the entire gold industry is relative to single companies like WalMart (WMT), Microsoft (MSFT), Exxon Mobil (XOM), or even whole industries. While the gold industry is rather small when viewed in this context, Casey Research points out that the silver industry pales in comparison to the gold industry. While I highlighted the fundamental reasons why silver stocks may be the top performing commodity class in 2009 (Precious Metals Update, 12.31.08), the small size of the industry is certainly another driver as to why silver stocks may have the ultimate upside if there is an investor precious metals rush in the months and years ahead.
Source: Casey Research: Casey’s Gold & Resource Report (09.15.09)
Source: Casey Research: Casey’s Gold & Resource Report (09.15.09)
In summary, the loose monetary policy and record fiscal budget deficits should not only concern US citizens but foreign investors in US securities as a weak USD will likely be the result in our futures. Concerns over inflation, the creditworthiness of the US government, as well as concerns of the USD’s purchasing power, will likely be key driving forces for higher gold prices ahead, acting as perhaps the gold trifecta. Currently the gold trifecta is signaling higher gold prices ahead as the year-over-year rate of change in the CPI has bottomed, the CDS spreads on 5-Yr UST notes is rising, and the USD can’t seem to find any support. We are still in the seasonally strong period for gold and we could see ,200 an ounce gold before the year is out. Perhaps THE key risk for gold is a strong USD rally. The first signs of a sustained USD rally would be a break above the 50 day moving average (50d MA), with a confirmatory signal given by a move of the 50d MA rising above the 200d MA, signals that marked the 2005 and 2008 USD cyclical bull markets.
Source: StockCharts.com
However, given the sustained low interest rate environment by the Bernanke Fed and record deficits, we may only see a mild USD rally before new lows are seen possibly by 2010. Knowing there exisits a large pool of central bank buyers for gold, Mr. Faber may be right that $1,000 ounce gold may be a thing of the past.
