Gold’s dramatic move above $1400 has caught the investment establishment by surprise. Physical gold ETFs, as a proxy for direct portfolio investment, amount to only 0.05% of the estimated $250 trillion of global investment values. As well as being badly wrongfooted, investment managers have little understanding of the role of gold as money, believing it to have no role in the monetary system. They will have to undergo a rapid re-education. This article addresses their common misconceptions.
Introduction
One month ago, gold made a dramatic move above a three-year consolidation (delineated by the pecked lines in Chart 1), confirming for technical analysts that a bull market in gold dating from the December 2015 low at $1,050 is alive and well. Chart 1 shows that a basing process has actually been in train for over six years, highlighted by the lower rectangular box.
Technically, the post-Lehman crisis bull market, when gold more than doubled, was ripe for a set-back. After peaking at $1920 intraday in September 2011, the Cyprus banking crisis in 2012 failed to collapse the Eurosystem and the gold price fell heavily. The topping-out process is highlighted by the upper smaller box in the chart. But that is now irrelevant. What is relevant is gold appears to be breaking out of a multiyear base, solid enough to offer the prospect of a potentially strong bull market in the dollar price of gold.
For trend-chasing investors who form a large majority by sheer weight of managed money, this is the primary consideration. They will have ignored the debate about the weaknesses of fiat currencies, geopolitical tensions with the Asian superpowers and America’s acts of trade immolation. That was always going to be the case until such time as gold broke convincingly through the $1350 technical price ceiling. With the price now establishing itself at over $1400, an appraisal of the reasoning behind gold’s breakout is timely for these investors.
The dollar price is no more than a headline indicator for investors whose portfolio performance is not measured in dollars. Gold’s performance measured in other currencies has been far better. Since the price peak in September 2011, by mid-December 2015 the dollar price of gold had lost 45% of its value and has recovered to a net loss of only 24%. The gold price measured in the other major three currencies has performed significantly better, with the price in Japanese yen even higher now than it was at the time of the dollar’s 2011 all-time high. This is shown in Chart 2.
Furthermore, while the dollar price has only just caught the attention of mainstream dollar investors, residents of Euroland and Britain have seen gold in euros and sterling recover to within six and four per cent of the 2011 high respectively. Nearly three months ago, it was said that the gold price in 72 currencies stood at all-time highs. Given that emerging market and developing economy currencies tend to be weaker than the majors it is probably true.
Those who watch dollar headlines before jumping on a trend are late arrivals to a party already in full swing. Since the dollar price of gold bottomed in late-2015, the sterling price aided by the Brexit debacle has risen 63%, proving to be an excellent hedge against a falling pound. Gold priced in euros is up 45% from its lowest point, proving the wisdom of ordinary Germans who are the largest group of gold buyers in the Eurozone.
At a time of zero and negative interest rates and bond yields, these returns are doubly impressive. But there are remarkably few bulls on board with reasonable portfolio exposure. According to the World Gold Council, at end-June gold ETFs held 2,548 tonnes of bullion worth $115bn at current prices. While there are other gold-related regulated investments and derivatives, this feedstock of the raw stuff is tiny compared with the total value of global portfolio assets, which is probably in excess of $250 trillion.[i] Given that nowhere is physical bullion a regulated investment, direct holdings of vaulted investment bullion are unlikely to be significant in this context. Putting physical gold being held as an unrecorded asset to one side, to find physical gold in investment portfolios you have to dig very deep. On these figures, ETF bullion represents only 0.046% of estimated global portfolio values.
Estimates of physical exposure in portfolios should not be taken too literally, but from these estimates we can see that for all practical purposes gold’s breakout has left the trend-chasing establishment with almost nothing. For this reason, there is now likely to be a scramble to understand why gold has broken out. Portfolio managers will be keenly aware they are likely to come under pressure from clients to participate and will want to have answers.
This article is addressed to the portfolio managers and investors who are in the unfortunate position of not yet owning any gold or find themselves underweight in gold-related investments and are considering what to do about it. But first we must dispel some of the common myths about the role of gold, so we can approach the subject with clarity.
Since we have presented our gold price framework the first time in late 2015, we have argued that we have entered a new cycle in the gold market. At the time we believed that longer-dated oil prices (5-year forward Brent) had likely set a bottom in late 2015 (at US$47/bbl, now US$60/bbl) and that real-interest rate expectations (10-year TIPS yields) were close to their cycle peak at 0.8% (now 0.3%) (see Exhibit 2). Our view was that – while there was some room to the downside – risk for gold prices were clearly skewed to the upside. While we weren’t extremely bullish near term for longer dated energy prices[1], the reason for our bullish view on gold was that we saw much more downside risk than upside risk for real-interest rate expectations.
By the end of 2015, the FOMC members were predicting terminal Fed funds rates at 3.5% (see Exhibit 3). The Fed also has a PCE (Personal Consumption Expenditure) inflation target of 2%, which, in our view translates into CPI (Consumer Price Inflation) of around 2.5-3% that is embedded in TIPS yields. Thus, we expected TIPS yields not rise much above 1% even if the Fed was able to raise rates as many times as it signaled at the time.
Importantly, with terminal rates at just 3.5%, any economic slowdown or even a recession would require the Fed to sharply slash rates, maybe to even negative territory, which in turn would bring down real-interest rate expectations. Hence, we argued that the next larger move in gold prices would likely be up due to declining real-interest rate expectations.
However, we also acknowledged that there was significant uncertainty about the path of real-interest rate expectations for the next few years. The Fed’s famous dot plot simply shows what the FOMC members expect for future nominal rates, not their stated target. A sharp pick-up in economic activity could allow the Fed to raise rates further. In our view, a “normal” 10-year treasury yield of 5-6% would have had quite a strong negative impact on gold prices. Assuming that the Fed would stick to its inflation target of 2%, real-interest expectations would most likely be around 2-2.5%[2]. All else equal, our model would predict gold prices to drop below US$1,000/ozt in such an environment.
In the aftermath of 2016 US presidential elections, that was exactly what the market started to price in. The market hoped that deregulation would unleash economic growth that would offset the negative impact of the Fed unwinding its balance sheet. And for a while, it looked like the economic environment in the U.S. did indeed gain steam and surprised both the market and the Fed. In turn, the FOMC members started to raise their expectations for terminal rates from just 2.75% back to 3%.
While this pushed 10-year inflation expectations from 1.2% in early 2016 to 2.2% in 2018, nominal rates rose even more quickly as the Fed was finally able to raise rates multiple times a year, pushing the 10-year Treasury yield to 3.2% in late 2018. The result was that real-interest rate expectations rebounded one more time to 1.2% (see Exhibit 4)
Gold has predictably struggled a little bit in this environment, but the dreaded gold bear market scenario never materialized. The price of gold was close to US$1,300/ozt before election day and it was down less than US$100/ozt by the time we saw peak rates late last year, despite also being in a bearish energy environment.
Part of the reason for this resilience is that, while the Fed tightened monetary conditions by raising rates and unwinding its balance sheets, central banks globally continued to ease, and total central bank assets are right now at an all-time high. This also explains why gold prices in some other currencies are also at all-time highs. On net, the up cycle that started in 2015 remains intact, and it just got confirmed by the Fed.
Based on the findings of our gold price framework, we have long argued that we have entered a new gold cycle. However, until now, there was always the risk that strong economic growth could allow the Fed to raise rates above what the FOMC members themselves expected was possible. As markets and the Fed itself rapidly adjust to the new reality of a slowdown in economic growth, those risks have subsided, bolstering our conviction that the next gold cycle is about to unfold.
In 2018 we published a 3-part series “Gold Price Framework Vol. 2: The Energy Side of the Equation” in which we presented our revised gold price model (part 1), took a deeper dive into the link between longer-dated energy prices and gold by doing an in-depth analysis of the energy exposure of gold mining companies (part 2), and gave an outlook for gold prices (part 3).
For those unfamiliar with our model, we recommend reading at least part 1 to get a better understanding of our findings in this report. In a nutshell, we found that the majority of changes in gold prices can be explained by just three drivers: Central bank policy (more specifically real-interest rate expectations and QE), changes in longer-dated energy prices, and central bank net gold purchases (the least important driver). These three drivers can explain over 80% of the year-over-year changes in the gold price (see Exhibit 1).
Based on the outlook for the main drivers of the gold prices, we reiterate our view that the risk to gold prices is clearly skewed to the upside, a position we are holding since early 2016. While our bullish view on gold remains unchanged, there is a clear change in our conviction level. For the past three years we have held the view that we are in a new up-cycle but we always maintained a somewhat cautious stance as we could see a near-term scenario where the Fed was able to continue to raise rates on the back of an acceleration in economic growth. We now think that this risk has all but vanished, with global economic growth pointing down, the FOMC members themselves cutting their future rate expectations and the market beginning to price in rate cuts rather than further rate hikes. In other words, the next cycle is about to unfold.
Never in all recorded history have financial markets been so distorted everywhere. In our lifetimes we have seen the USSR and also China under Mao attempt to do without markets altogether and fail, having starved and slaughtered millions of their citizens in the process. The Romans started a long period of currency debasement, lasting from Nero to Diocletian, who wrote prices in stone (the origin of the phrase) in a vain attempt to control them. While the Roman Empire was the known world at the time, it was essentially restricted to the Mediterranean and Europe. Subsequently, there have been over fifty instances recorded of complete monetary collapse, the vast majority in the last hundred years, which have led to the breakdown of every society involved.[i]And now we could be facing a global totality, the grand-daddy of them all.
We have become inured to cycles of credit expansion, driven by fractional reserve banking at least since the Bank Charter Act of 1844, which legalised fractional reserve banking. Extra impetus was given by central banks from the 1920s onwards. We have become so used to it that we now expect central banks to issue and control our money and only get really worried when we think they might lose control. In their efforts to satisfy the mandate they have assumed for themselves central banks intervene more and more with every credit cycle.
Our complacency extends to prices, especially regarding the exchange and valuation of capital assets. There are now about $13 trillion of bonds in issue with negative yields. We rarely think in any depth about this strangeness, but negative yields are never the consequence of market pricing free from monopolistic distortions. The ECB, the Bank of Japan and the Swiss National Bank all impose negative interest rates, as well as Sweden’s Riksbank and Denmark’s Nationalbank. The ECB commands the currency and finances of the largest economic area in the world and the BoJ the third largest national economy. In Denmark, mortgage lenders are even offering negative-yield mortgages: in other words, Danes are being paid to take out loans with negative interest rates.[ii] Ten-year government bonds issued by Germany, Japan, Sweden and even by France have negative yields. All Danish government bonds have negative yields.
Negative yields stand time-preference on its head. Time-preference refers to the fact that we prefer current possession to future possession, for obvious reasons. So, when we part with our money we always do so at a discount to expected repayment, which is reflected in a positive rate of interest. The idea that anyone parts with money to get less back at a future date is simply nuts.
It gets even more bizarre. The French government has debts roughly equal to France’s GDP and by any analysis is not a very good credit risk, but it is now being paid by lenders to borrow. Only forty per cent of her economy is the productive tax base for a spendthrift, business-emasculating government. An independent observer evaluating French government debt would be hard put to classify it as investment grade in the proper meaning of the term. But not according to bond markets, and not according to the rating agencies which today’s investors slavishly follow.
There are a number of explanations for this madness. Besides complacency and misplaced investor psychology, the most obvious distortion is regulation. Investors, particularly pension funds and insurance companies are forced by their regulators to invest nearly all their funds in regulated investments. Their compliance officers, who are effectively state-sponsored bureaucrats, control the investment decision process. Portfolio managers have become patsies, managing capital with little option but to comply.
Additionally, with their highly-geared balance sheets state-licenced banks complying with Basel II and III are also corralled into “riskless” assets, which according to the regulators are government debt. The rating agencies play along with the fiction. For example, Moody’s rates France as Aa2, high quality and subject to very low credit risk. This is for a country without its own currency to inflate to repay debt. Low enough for negative yields? Low enough to be paid to borrow?
In Japan, the country’s government debt to GDP ratio is now over 250%. The Bank of Japan maintains a target rate of minus 0.1%, and the 10-year government bond yield is minus 0.16%, making the yield curve negative even in negative territory. It doesn’t stop there, with the Bank of Japan having bought 5.6 trillion yen ($52bn) of equity ETFs last year. This takes its total equity investment to 29 trillion yen ($271bn), representing 5% of the Tokyo Stock Exchange’s First Section. Last year’s purchases absorbed all foreign selling of Japanese equities, so they were clearly aimed at rigging the equity market, rather than some sort of monetary manoeuvre.
It’s not only the Bank of Japan, but the National Bank of Switzerland has been at it as well. According to its Annual Report and Accounts, at end-2018 it held CHF156bn in equities worldwide ($159bn), being 21% of its foreign reserves. We can see the direction central bank reserve policy is now heading and should not be surprised to see equity purchases become a wide-spread means of rigging stockmarkets and expanding base money.
Sovereign wealth funds, which are government funds that owe their origin to monetary inflation through the foreign exchanges, have invested a cumulative total of nearly $2 trillion dollars in listed equities.[iii] While this is only 2.5% of total market capitalisation of listed securities world-wide, they are a significant element in marginal pricing, more so in some markets than others.
Between them, central banks and sovereign wealth funds that are buying equities in increasing quantities further the scope of quantitative easing. The precedent is now there. Economists in the central banking community now have a basis for drafting erudite neo-Keynesian papers on the subject, giving cover for policy makers to take even more radical steps to pursue their interventions.
By all these methods, state control of regulated public and private sector funds coupled with the expansion of bank credit has cheapened government borrowing, and it would appear that governments are now enabled to issue limitless quantities of zero or negative-yielding debt. So long as enough money and credit is fed into one end of the sausage machine, it emerges as costless finance from the other. Never mind the destruction wreaked on key private sector investors, such as pension funds, whose actuarial deficits are already in crisis: that is a problem for later. Never mind the destruction of insurance fund finances, where premiums are normally supplemented by healthy bond portfolio returns. Just blame the insurance companies for charging higher premiums.
This is now the key question: are we entering a new phase of low-inflation managed capitalism, or are we tipping into a mega-crisis, possibly systemically destructive?
If the latter, there’s a lot to go horribly wrong. The Bank for International Settlements, the central banks’ central bank, is certainly worried. Only this week, it released its annual economic report, in which it said, “monetary policy can no longer be the main engine for economic growth.” Clearly whistling to keep our spirits up, it calls for structural reforms to boost government spending on infrastructure. Translated, the BIS is saying little more can be achieved by easing monetary policy, so Presidents and Prime Ministers, it’s over to you. You can create savings by making government more efficient and you can spend more on infrastructure.
While the BIS washes it hands of the problem, history and reason tell us increased state involvement in economic outcomes will only make things worse. It is in the nature of government bureaucracy to be economically wasteful, because its primary purpose is not the efficient use of capital resources. And while the outcome, be it a new high-speed railway or a bridge to nowhere may be a visible result, it fails to account for the true cost to the economy of diverting economic resources from what is actually demanded.
