“The Heisenberg principle — If something is closely observed, the odds are it is going to be altered in the process. The more a price pattern is observed by speculators the more prone you have false signals; the more the market is a product of nonspeculative activity, the greater the significance of technical breakout— Bruce Kovner
From the Financial Times (emphasis added):
“Gold has long been seen as a hedge against inflation and a haven in times of stress. But it surprised many analysts in the coronavirus sell-off by falling alongside equity markets as investors opted for the safety of cash. Gold dropped from nearly $1,680 on March 9 to just above $1,450 on March 16, shortly before the S&P 500 hit a more than three-year low.
The chart above is of the expected real yield on US 10-year Treasury bonds versus the price of gold (inverted).
Any analysis of gold should begin with the presumption that gold is a currency not a commodity. That is, the price of gold is driven by global liquidity conditions rather than its utility — occasional bouts of safe haven demand notwithstanding. Essentially, gold reflects the imbalances between liquidity and economic activity.
During periods when liquidity is in excess of economic activity, gold will rise. While in periods when liquidity is scarce relative to economic activity, gold prices will fall.
Loosely, the excess or scarcity of liquidity is captured by the supply (or quantity) of fiat, the velocity of (or demand for) said fiat and real rates. Of the three components, real rates are the highest frequency component, while velocity of money is the lowest. Therefore, on shorter-term timeframes real rates tend to be the primary driver of fluctuations in the price of gold. Over the longer-term, however, velocity of money plays an important role.
The sell-off in gold, alongside the sell-off in equity markets, highlighted by the Financial Times was triggered by a sharp spike in real rates. In this instance, said spike was due to a much larger drop in inflation expectations than in US Treasury yields. There is not much more to it and since inflation expectations have recovered much more than bond yields on the back of large scale monetary and fiscal stimulus, so too has the price of gold.
Gold traders should closely follow inflation expectations, any break lower should be taken as an opportunity to reduce allocations. Until such time, traders can continue to hold ‘barbaric relic’.
Debt Deflation
In an over-indebted world, there is a significant risk of debt deflation, as articulated by Irving Fisher, being triggered by a negative shock, such as a global pandemic, that either obstructs global liquidity flows or drives up real interest rates.
Given rising geopolitical and trade related tensions, be it within Europe or between the US and China, and a synchronised global slowdown in economic activity forced by the coronavirus pandemic, there is a real risk of global liquidity conditions worsening. This worsening can occur despite the best efforts of central banks to flood the global economy with dollars, euros and yen.
Given that the US dollar is the global reserve currency, US dollar liquidity can be used a proxy for global liquidity conditions. We use commercial bank loans outstanding for the ‘quantity’ of money and adjust this metric for the velocity of money supply, M2, and US 10-year real rates. That is, we focus on ‘private’ dollar supply and not on ‘government’ driven dollar supply. (Note: We have used realised inflation rather than inflation expectations to calculate real rates as more data was available for the former.)
The chart above plots the 18-month rate of change in US dollar liquidity to the inverse of the 18-month rate of change in the US dollar exchange rate. Rising US dollar liquidity translates into a weaker greenback and vice versa.
As can be seen in the chart, even before the global economy came to a standstill, US dollar liquidity had started tightening during the fourth quarter of 2019. In response to the global pandemic, and despite the actions of the Fed, private sector driven dollar creation is only going to contract further. For instance, according to the Fed’s senior loan survey “respondents to the April survey indicated that, on balance, they tightened their standards and terms significantly on commercial and industrial (C&I) loans to firms of all sizes.”
Tightening credit standards, tighten US dollar liquidity.
Tightening US dollar liquidity eventually translates into a stronger dollar. Maybe not today but over the coming 3 to 6 months, the risk of a much stronger greenback remains quite high.
While gold is not always the other side of the US dollar, a rising dollar is a headwind.
What About Central Bank Created Liquidity?
When liquidity creation and destruction is led by the private sector it is generally in response to rising or diminishing prospects for economic activity. Whereas government led liquidity creation and destruction usually occurs when market transmission mechanisms are failing or being corrupted.
Diminishing economic prospects typically lead to an increased demand for savings (falling velocity) while rising economic activity typically causes velocity to rise.
The various iterations of quantitative easing conducted by the Fed in the aftermath of the global financial crisis were an expansion of public liquidity supply to counter the ill effects of a private sector that was destroying liquidity. Overall, public sector supply was gradually over-whelmed by increasing savings, which led to the fall in gold in 2011.
Similarly, in response to the coronavirus pandemic, the monetary and fiscal measures taken by the Fed and US Treasury are going towards countering the haemorrhaging of liquidity by households and corporations. Given the uncertainty, sharp increases in unemployment and diminished savings, velocity of money, we think, will continue to deteriorate as the private sector seeks to repair its balance sheet.
Barring a huge fiscal stimulus program that kickstarts economic activity, we think declining velocity will eventually overpower central bank created liquidity. This is in turn should push the dollar higher and inflation expectations lower.
We think the 6 to 12 months prospects for gold point to lower not higher prices.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.