gold Archives - LXV Research

Inflation Expectations, Global Liquidity & Gold

“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.

1-58

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.)

2-58

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.

Loan Growth, US Dollar Liquidity Dynamics and Gold

“A man who is used to acting in one way never changes; he must come to ruin when the times, in changing, no longer are in harmony with his ways.” ― The Prince (1532), Machiavelli Niccolò

A quote-heavy piece to aid us as we start thinking about and preparing for 2020. In this week’s piece we focus on US dollar liquidity and gold.

Before the update, we wanted to comment on many people bemoaning President Trump’s habit of tweeting market moving news, or that purported to be news, in and around market trading hours. Whilst unfortunate, as the following quote from Robert E. Shiller shows, President Trump is not the first and unlikely to the be the last US President trying to nudge the equity market higher:

President Calvin Coolidge was an exceptionally pro‑business president. His most famous quote is “The business of America is business.” He was criticized for not bringing artists and classical musicians to the White House. He just brought businessmen. He liked businessmen. He believed in them. Whenever the stock market had a downturn, he would get on the radio — or Andrew Mellon, his US Treasury secretary would. Coolidge thought that was his job, to reassure the Americans that business is sound and profitable. It led to the biggest stock market boom seen at that point in history. I think it shows that political leaders do have an influence on the markets, so we can learn lessons.

On to the update.

Commercial and Industrial Loans

From Interest Rates, the Markets and the New Financial World (1986) by Henry Kaufman (emphasis added):

With the onslaught of deregulation, financial innovation, and new technology, government officials have urged private market participants to limit their zeal―as one authority recently put it, “to suppress the drive to reach out for that one last deal or that last basis point of profit.” These pleas are laudable but ineffective. Market participants cannot avoid being caught up in debt creation. If they turn their backs on the world of securitized debt, proxy debt instruments, and floating-rate finance, they will lose market share, fail to maximize profits, and be unable to attract and hold talented people.

The driving force for underlying profits is credit growth, and in the process the most conservative among institutions compromise standards and engage in practices that they would not have dared pursue a decade or two ago. The heroes of credit markets without a guardian are the daring―those who are ready and willing to exploit financial leverage, risk the loss of credit standing, and revel in the present casino-like atmosphere of the markets.

From Money creation in the modern economy, issued in the Bank of England’s Quarterly Bulletin 2014 Q1:

Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy. But they are far from the only ways. Deposit creation or destruction will also occur anytime the banking sector (including the central bank) buys or sells existing assets from or to consumers, or, more often, from companies or the government.

Banks buying and selling government bonds is one particularly important way in which the purchase or sale of existing assets by banks creates and destroys money. Banks often buy and hold government bonds as part of their portfolio of liquid assets that can be sold on quickly for central bank money if, for example, depositors want to withdraw currency in large amounts.

According to the Federal Reserve’s most recent senior loan officer survey released last month, banks left commercial and industrial lending standards mostly unchanged amid weakening demand in the third quarter of 2019. Weakening demand for credit from the commercial and industrial sectors means that residential mortgage demand is the only engine for credit growth in the US economy at present. That is not a healthy dynamic. If not loan demand, particular from corporations, remains weak this will call into question the continuation of the US’s record long economic expansion.

Liquidity Metrics Do Not Signal A Continuation of the Gold Rally, At Least Not Yet

The below chart is of the price of gold, in US dollars, versus and adjusted metric of US broad money supply, M2.

Gold and M2.png

We have adjusted money supply such that a rising (magenta) line indicates that the creation of dollar liquidity in the monetary systems exceeds the needs of the economy. Excess liquidity creation translates into a debasement of the currency relative to real assets. A declining line is indicative of the monetary system not generating sufficient liquidity as demanded by the economy.

Gold functions both as a safe haven and a real asset. Therefore, its price has three broad drivers: the demand for safety (or high-quality collateral), the amount of excess liquidity being created by the monetary system and the level of real interest rates. Outside of periods of economic uncertainty, the primary determinate of the price of gold is the level of excess liquidity being generated.

As we can see from the above chart, there has been very little excess US dollar liquidity being generated by the economic system. Rather, the level of liquidity has just about been sufficient to support the US economy’s demand for dollars and this does not take into account the demand emanating from other economies. Therefore, the price of gold has been driven by demand for safe haven assets and declining real yields, which to an extent also reflect safe have demand.

With demand for credit in the US remaining tepid, as discussed above, we do not expect excess dollar liquidity manifest. Rather, an accelerant coming from either a further loosening of monetary policy by the Fed, the US Treasury draining its cash reserves or some form of fiscal stimulus are the obvious candidates that can lead to increases in dollar liquidity.

For now, with real yields starting to rise gradually, the only bid in gold, we think, is that of capital in search of high-quality collateral.

The Repo Facility is not Gold Neutral

The repo blow-up earlies this year set markets on edge and prompted the Fed to pump billions of dollars of emergency funding into the financial system. That is not all, the Fed has indicated that it will pump almost half a trillion dollars into the financial system over the end of the year, dramatically increasing intervention in the market in an attempt to avoid a repeat of September’s alarming rise in short-term borrowing costs.

The expansion of the Fed’s balance sheet and the pumping of US dollars into the repo market has been seen by some as bullish for gold. We think that drawing such conclusions is perilous for investors. Adding liquidity to the repo market to increase reserves is not akin to generating excess liquidity because adding liquidity into the financial sector’s “plumbing” does not result in said liquidity making its way into the economy. Rather this liquidity remains in the financial system, allowing it to operate without, hopefully, any further hiccups.

If this is not completely clear, we apologise and request you to please get in touch as we can share articles from those better placed to discuss the intricacies of the repo market and the plumbing that underpins the financial system.

A Mix of Macro Charts

“The Federal Reserve has an official commitment to two different policies. One is to prevent inflation from getting too high. The second is to maintain high employment… the European Central Bank has only the first. It has no commitment to keep employment up.” ― Noam Chomsky

“A small group of people, they raise the price of oil and the whole world will suffer from this.” ― Ahmed Zaki Yamani, minister in OPEC for 25 years

A Mix of Macro Charts

In this week’s piece we share three macro charts that we hope will provide readers with an insight on how various risks are priced in markets by a seeming disparate range of instruments and indicators.

Short-Term Rates and the Yield Curve

YC 3m bills

The above chart is of the de-trended 3-month Treasury bill rate (inverted) ― de-trended by subtracting the 10-year moving average from the bill rate ― versus the US Treasury 10-year and 3-month yield curve. The chart dates from 1962 till today, suggesting that the de-trended 3-month Treasury bill rate contains information about the direction of the yield curve.

The two-time series have a correlation of -0.77 with an r-squared of 59 per cent.

(The dashed lines on the above chart are the average de-trended bill rate and levels one standard deviation above and below the average.)

The relation between the de-trended bill rate and the yield curve indicates a strong tendency of interest rates to mean revert. The wider the gap between the current de-trended bill rate and its long-term average, the stronger the markets expectation of mean-reversion. For example, the de-trended bill rate being one standard deviation above (below) its average generally serves as a guide post to position for a yield curve steepening (flattening / inversion). (The time series is inverted, so above the average means visually below on the chart.)

The de-trended bill rate recently reached one standard deviation above its long-term average and has since turned down, suggesting that fixed income investors position for a yield curve steepening, as opposed to a direct long or short position at either end of the curve.

Equity market investors can play a steepening yield curve by being long financials.

The Golden Period of Risk-Parity and 60/40 Allocations

stock bond correl

The above chart is the 6-month rolling US stocks-to-bond correlation and the 6-month rolling average of the annual rate of inflation, as measured by the consumer price index.

The relationship demonstrates (1) how the capital markets price in inflation and (2) the correlation between stocks and bonds is not static. The implication of the latter is that bond allocations do not always serve as a suitable diversifier for equity allocations. Rather, it is the prevailing market regime that determines the efficacy of bond allocations to lower draw downs and portfolio level volatility during equity market sell-offs.

Capital markets price in inflation ― outside financial crises when the safe haven demand for bonds can overwhelm implicit inflation expectations ― through an adjustment of the correlation between stocks and bonds. During the period from 1965 through to 1997, when inflation expectations experienced large swings, the stock-to-bond correlation was almost consistently positive. That is, changes in inflation expectations drove both stock and bond returns and during periods of equity market weakness bond allocations did not make up the difference. For example, in the sub-period between 1973 and 1981, during which there was a negative supply shock from the OPEC oil export embargo, multiple recessions, high unemployment rates and high inflation, equity market weakness coincided with a poor bond market performance.

To re-iterate the point again, it is market regime that determines whether Treasury bonds are a “wonderful hedge” or a “terrible investment”. Moreover, we can from the chart above why the last decade and a half has been a golden period for risky parity strategies and 60/40 allocations ― stock-to-bond correlations have been and remained at or close to 100-year lows.

The question then is, how does one determine market regime?

Market regime is just another way of saying inflation expectations. Rising inflation expectations equate to rising stock-to-bond correlations. Retreating inflation expectations translate to declining stock-to-bond correlations. By extension, something touched upon last week, the combination of stable, that is expectations of more of the same, and low-levels of inflation makes for the optimal investment environment.

Continuing to bet on more of the same when stock-to-bond correlations have been at 100-year lows for a prolonged period is surely asking for trouble. All the more, with political movements the world over nudging the global economy from being driven by negative and positive demands shocks to becoming one that will be driven by positive and negative supply shocks, a market regime change seems inevitable.

Demand shocks, either positive or negative, do not move the Phillips curve; supply shocks, however, shift it in and out. When the Phillips curve shifts in response to a negative supply shock, nominal bonds exacerbate losses suffered in equity markets. For example, an adverse supply shock in the form of the oil embargo by the OPEC in 1973 shifted the Phillips curve by increasing both production and distribution costs of almost all industries and led to losses for both equity and bond market investors.

That is why we think investors need to consider instruments other than bonds to hedge equity allocations. The Japanese yen, precious metals, Treasury Inflation-Protected Securities (TIPS), oil and energy stocks are some of the viable options. It is likely that there are others.

Why do we keep insisting on oil and energy stocks? Well because oil is the most obvious negative supply shock we can conceive of in the event of an Elizabeth Warren or Bernie Sanders presidency. Both Democratic presidential contenders have proposed to ban fracking altogether.

Europe Sovereign Risk Model

euro sov risk.png

The above chart is the ratio of gold, in euros, to the Euro Area all shares index versus the differential between 10-year government bond yields of the ‘fragile’ European economies and Germany. (For the latter we use the average of the yields on Spanish, Portuguese and Italian 10-year bonds and subtract from it the yield on 10-year German bonds.)

The two series are a means of measuring sovereign, or break up, risk in Europe. Rising ratios imply rising sovereign risks and a rush towards the safe havens of gold and German debt. Recently, with gold having rallied and some form of Brexit related agreement forming, the two time series have diverged. The yield differentials indicate a declining risk premium while the gold-to-shares ratio indicates a rising risk premium.

We think the two series should start to converge with European stock markets continuing to head higher.

Inflation, Earnings Yields, Stock Prices and Gold

We examine the relationships between inflation, stock prices, valuation multiples, real yields and gold. 15 Nov 2019.

“To understand is to perceive patterns.” ― Sir Isaiah Berlin (1909 – 1997)

“The great hope for a quick and sweeping transition to renewable energy is wishful thinking.” ― Vacliv Smil

Amazon has been in the news lately and not for the right reasons:

Nike has ended its deal with Amazon to sell its shoes and clothing directly to consumers on the e-commerce website. Nike cited a lack of follow through on Amazon’s part to crack down on sales of Nike branded products by unlicensed distributors and knockoffs by third-party sellers.

Amazon has accused the US government of having exhibited an “unmistakable bias” for the Pentagon awarding the US dollars 10 billion Jedi cloud computing contract to Microsoft after several rounds of bidding.

All does not seem right at Amazon. Probably making it one of the large cap stocks to avoid even as the US equity market continues to head higher.

On to this week’s update.

Inflation, Earnings Yields, Stock Prices and Gold

Federal Reserve Chairman Jay Powell told lawmakers at the Congressional Testimony that he saw little need to cut interest rates further after making three reductions since July. He also expressed that US inflation should progressively rise toward the Fed’s target rate of 2 per cent.

The day before Chairman Powell’s testimony, President Trump criticised the Fed for keeping rates too high and expressed envy towards nations in Europe that have interest rates below zero.

President Trump, understandably, wants higher stock prices and a booming economy as the US heads into an election year. Since stock prices are supposed to reflect the values of discounted future cash flows, a lower discount rate and / or high earnings growth expectations should translate into higher stock prices. President Trump cannot goose up earnings as easily as the Fed can cut interest rates, from his perspective, it then makes sense that he goes after the Fed and its hawkish stance, relative to that of the European Central Bank and Bank of Japan, on monetary policy.

Assuming lower policy interest rates translate into a lower discount rate, the US equity market’s earnings yield should decline (or price-to-earnings ratio increase). Barring a sharp drop in earnings, a lower earnings yield equates to higher stock prices.

The fly in the ointment is that, historically, US earnings yields have been more closely related to the rate of inflation than to nominal or real bond yields. And, high price-to-earnings ratios have had modest predictive power over future earnings growth.

The chart below is of the trailing earnings yield of US stocks and realised inflation rates.

Earning Yield and Inflation.png

A comparable relationship between inflation and earnings yields exists in many other markets as well.

Theoretically, since stocks are real assets, changes in the rate of inflation should not have a meaningful impact on stock prices or valuation multiples. In practice, however, the principle does not hold. Studies in behavioural finance suggest that a cognitive bias, known as the “money illusion”, explains the theoretical and practical disconnect that makes equity markets undervalued when inflation is high and overvalued when inflation is low.

The money, or price, illusion is to think of money in nominal, rather than real, terms. That is, when inflation is high (low), market participants incorrectly discount real cash flows using nominal discount rates, resulting in an undervalued (overvalued) price.

Explanations based on cognitive biases, such as the money illusion, while appealing, lack explanatory power however. That is, analysis reveals the ‘sweet spot’ for equity valuations occurs when the rate of inflation is in the range of 1 to 4 per cent. Valuation ratios compress at rates of inflation both above and below this range. Markets like neither high-levels of inflation nor deflation.

This is bad news for long-term equity investors that consider the probability of one of either deflation or high inflation occurring in the future to be higher than the level of inflation being witnessed in the US economy at present.

Relation Between Gold and the Price-to-Earnings Ratio

PE vs SPGOLD.png

The above is a chart of the S&P 500 Index express in terms of gold (in US dollars per Troy Ounce) versus the index’s price-to- ratio. In simple terms, the price of gold is inversely correlated to the price-to-earnings multiple of the index.

This relation can be better visualised by using the cyclically adjusted price-to-earnings (CAPE), or Shiller price-to-earnings, ratio as the impact of the Global Financial Crisis is smoothed out.

CAPE SPGOLD.png

Outside of periods when demand for high-quality, liquid collateral is at a premium, such as during a financial crisis, the price of gold is generally driven by the trend in US real yields. Rising real yields, that is rising interest rates and / or declining inflation, tend to push gold lower. While declining real yields, that is declining interest rates and / or rising inflation, tend to push gold higher.

The critical question for investors in US equity markets, or any other stock market for that matter, to ask then is: where are real yields headed?

Higher real yields translate into expanding valuation multiples implying that positive returns can be generated even with benign levels of earnings growth. While shrinking real yields are likely to spell negative returns unless earnings really surprise to the upside.

With Mr Powell signalling that the Fed is done cutting rates for now, if a drop in real yields is to manifest, it is more likely to come from a spike in inflation. With the continued reluctance of US corporations to make capital investments, the most likely candidate to lead a spike in inflation, in our opinion, is an unexpected rise in the price of oil.

Equity market multiple contraction risk can be hedged by owning gold or by investing in oil related plays such as companies operating in the energy sector. With gold having rallied to multi-year highs just recently and energy stocks trading at or near multi-year lows, our preference is for the latter.

Safe Haven Bid: Ahead of Itself?

Marilyn: Thank you for coming over, Mr. Baer. Welcome back and forgive me if I wade right in, but forgetting for a second your bureaucratic checklist, I’m trying to get undigested information, so if you could give me a reading of the temperature over there?

India is now our ally. Russia is our ally. Even China will be an ally. Everybody between Morocco and Pakistan is the problem. Failed states and failed economies, but Iran is a natural cultural ally of the U.S. The Persians do not want to roll back the clock to the 8th century.

I see students marching in the streets. I hear Khatami making the right sounds. And what I’d like to know is if we keep embargoing them on energy, then someday soon are we going to get a nice, secular, pro-Western, pro-business government?

Bob: It’s possible. It’s complicated.

Marilyn: Of course it is, Mr. Baer. Thank you for your time.

Intelligence is the misnomer of the century.

Bob: They let young people march in the street and then the next day shut down fifty newspapers. They have a few satellite dishes up on roofs, let ’em have My Two Dads, but that doesn’t mean the Ayatollahs have relinquished one iota of control over that nation.

Distinguished Gentlemen: Mr. Baer, the reform movement in Iran is one of the President’s great hopes for the region and crucial to the petroleum security of the United States.

Terry George: These gentlemen are with the CLI.

Distinguished Gentlemen: The Committee for the Liberation of Iran, Mr. Baer

Bob: We’ve had Iran in embargo for almost thirty years, we backed their neighbor, a neighbor we invaded twice, in a ten year war against them, we’re hanging on by a thread with a massive occupation force, so I got news for you… Thomas Jefferson just ain’t that popular over there right now.

― Syriana (2005)

Iranian foreign minister, Javad Zarif, made a surprise visit Sunday to the the Group of Seven summit, meeting with a delegation including French President, Emmanuel Macron, as leaders grappled with how to defuse tensions and salvage the landmark nuclear deal after a US pullout.

Mr Javad Zarif did not meet with the US delegation in Biarritz, France, although President Trump has indicated that he is open to meeting Iranian officials without preconditions.

The narrative in the noughties when oil was rallying and the spectre of peak oil (supply not demand) was of popular concern ― the BBC even produced a film titled The Crude Awakening: The Oil Crash in 2007 to warn of the end of life as we know it because the world was running out of oil ― was that of the US’s need to ensure hydrocarbon security. Today, the narrative is that the world is awash with oil and the US is energy independent, affording President Trump the luxury to scrap the deal with Iran and to re-impose economic sanctions.

As it relates to oil, the truth lies somewhere in between the fears over peak demand and peak supply but almost never, barring a energy paradigm changing supply- or demand-shock, at the extremes.

As it relates to geopolitics, should oil prices rise sufficiently, driven by a flurry of bankruptcies in the US shale patch or US shale production plateauing, it would be of no surprise to see the US either return to the negotiating table with Iran or to ease sanctions.

The overarching consensus for oil appears to be that of lower oil prices. With some even calling for a crash to below the US dollars 30 per barrel level, that would lead to global deflationary bust. In our opinion, these calls seem premature. Rather, if anything, we see the greater risk being to the upside.

We often use the 48-month moving average, for commodities and major currency crosses, to guide our trading strategy. For now, WTI crude prices remain above the moving average, albeit just barely. Given the proximity of the current price to the moving average, the best course of action may be to be on the sidelines. That being said, as long as prices do not meaningfully breach the 48-month moving average, our bias is to be long in expectation of prices climbing the ‘Wall of Worry’ over the next 6 to 12 months.

USCRWTIC Index (US Crude Oil WTI 2019-08-26.png

Has the Safe Haven Bid Got Ahead of Itself?

In the below chart, the magenta line is the ratio of the price of gold to the Merrill Lynch 10-year Treasury Total Return Index. The orange line is that of core price index.

XAU Curncy (Gold Spot $_Oz) GL 2019-08-26 11-47-07

The US dollar price of gold, loosely an inflation hedge, rising relative to the 10-year Treasury index generally coincides with rising core inflation. There, of course, are periods that the ratio over- or under-shoots core inflation but over time the roughly coincident movement of core inflation and the gold-to-ten-year Treasury index tends to reassert itself.

In recent months we have seen safe haven assets, government bonds and precious metals, get bid up. Notably, gold has outperformed 10-year Treasury bonds in 2019 even as core inflation has witnessed a sharp drop. Between early 2017 and early 2018 we saw a similar dynamic play out, when long-term bond yields rallied (long bonds sold off) and gold remained steady while at the same time core inflation moved sharply lower.

In 2018, core inflation eventually moved higher and caught up with the gold-to-Treasuries ratio. Suggesting that markets had correctly anticipated the move higher in core inflation.

We will know in time if the markets have got it right again or not. If core inflation does not move higher, it is likely that the safe haven bid, specifically in gold and other precious metals, has gotten ahead of itself and investors are better off owning government bonds over precious metals.

With long-term bond yields near all-time lows, it is difficult to make a strong case for bonds, however.

The below chart is that of WTI crude (magenta) and gold (orange). The two commodity prices tend to, over the long-term, have the same directional move. Oil does not have the safe haven characteristics of gold and therefore has stronger moves than gold both to the up and down sides.

USCRWTIC Index XAU (US Crude Oil WTI 2019-08-26.png

Much like the relation between the gold-to-Treasuries ratio and core inflation, a gap has opened up between the price of gold and that of oil, much like it did in 2017. In 2018, the gap was closed with oil moving higher. Will that also be the case this time around?

Finally, the last chart in this week’s piece. This one compares the price of oil to core inflation.

USCRWTIC Index PCE.png

The price of oil is one of the primary drivers of core inflation, albeit with a lag. Should oil prices move higher from here, core inflation will be higher 6 to 12 months down-the-line; justifying the move higher in gold and likely proving the current rally in government bonds to be a bull trap.

On the other hand, if oil prices make new lows, gold should be sold in favour of government bonds.

The price of oil is probably the most important price in capital markets today. The next move in oil will drive many of key tactical decisions for asset allocators.

If oil moves higher, portfolios will be found to be lacking allocations to assets that do well in periods of rising inflation ― resource and mining companies, resource rich emerging markets, high yield credit and precious metals ―and over exposed to high duration assets such as loss-making technology companies as well as utilities and long-terms bonds.

If oil moves lower, the stampede into developed market government bonds, technology stocks and utilities is likely to continue unabated.

We will be following the oil price ever so closely hereon out.

Thought Experiment: China Oil for Gold Contracts

“Too many people in the modern world view poetry as a luxury, not a necessity like petrol. But to me it’s the oil of life.” – Sir John Betjeman, English poet, writer, and broadcaster

“Oil is like a wild animal. Whoever captures it has it.” – J. Paul Getty

“Gold is a treasure, and he who possesses it does all he wishes to in this world, and succeeds in helping souls into paradise.” – Christopher Columbus

“We Spaniards know a sickness of the heart that only gold can cure.” – Hernan Cortes

China imports a lot of oil and produces very little of it. And for all its progress, the People’s Republic has been able to do very little in overcoming its dependence on the black stuff. In fact, even a cursory glance at a time series of Chinese import statistics shows that, China is becoming increasingly more dependent on oil imports.

This is the price China pays to be the ‘factory of the world’.

China Oil Imports China Imports.png Source: BP Statistical Review

Oil is priced in US dollars. Oil importing nations have but no choice to hold US dollars. This is ‘American Privilege’.

No wonder then when the price of oil goes up, especially when US dollars are becoming increasingly difficult to come by, oil importing nations suffer a liquidity squeeze and see their economic performance deteriorate in short order.

The price of Brent crude averaged US dollars 54 per barrel last year; year-to-date it has averaged almost US dollars 72 per barrel – close to a third higher. It follows then that the stock markets of many of the largest oil importers amongst the emerging economies have had a torrid time of it this year.

Emerging Market Indices Year-to-Date Total Return (US dollars)Source: Bloomberg, Note: MSCI Indices

China, if it is to realise its economic and geopolitical ambitions, must overcome this oil price and liquidity conundrum. Unless China discovers the equivalent of the Ghawar oilfield in Saudi Arabia or undergoes a Permian like shale revolution, the solution to this problem is likely to be found in a reconfiguration of Chinese capital markets.

In March this year, China launched renminbi-denominated oil futures, which coincidentally is also the first Chinese futures product that can be traded by overseas entities without a presence in China. Simply launching an oil futures contract, however, is not enough especially for an economy with a closed capital account.

While the prospect of a renminbi-denominated oil contract may appeal to oil exporters, such as Russia and Iran, that have suffered from the weaponised dollar, the contract on its own provides nothing more than a case of out of the frying pan and into the fire. Most oil exporters, we suspect, are far more willing to trust the United States than China given the status quo. For this reason, China must do more to provide the necessary comfort to oil exporters to trade in renminbi and a means for them to swap their renminbi for other more freely tradable assets.

China has taken steps to provide two alternatives to anyone settling physical deliveries in renminbi. The first is the equivalent of the US petrodollar model whereby renminbi receipts can be recycled into Chinese bonds with the gradual opening up of the Chinese bond market. The second is the back-to-back conversion of renminbi-denominated oil contracts into renminbi-denominated gold contracts for physical delivery in gold.

The latter solution is particularly intriguing because it eliminates the need for trust and rewards exporters in the form of an unencumbered asset.

Thought Experiment

From Wikipedia:

A thought experiment considers some hypothesis, theory, or principle for the purpose of thinking through its consequences. Given the structure of the experiment, it may not be possible to perform it, and even if it could be performed, there need not be an intention to perform it.

With China completing the first physical delivery for crude futures yesterday, we think it a good time to think through the non-conspiratorial implications of the oil for gold structure that China is offering for oil settlement.

The relevant statistics to think this through are as follows:

Chinese oil imports have now reached 8.4 million barrels per day or 3.066 barrels per year

At US dollars 70 per barrel that translates into an annual oil import bill of US dollars 214.62 billion; growing at 3 per cent per annum this would take Chinese spending in oil imports to over US dollar 315 billion by 2030

Chinese gold mine output is estimated at around 450 tonnes per annum and expected to rise to 500 tonnes by 2020

At US dollars 1,200 per troy ounce, Chinese gold mine output of 500 tonnes translates to US dollars 19.29 billion; at US dollars 1,600 per troy ounce it translates to US dollars 25.72 billion

Global gold production is estimated 3,150 tonnes per annum

At US dollars 1,200 per troy ounce, global gold production is valued US dollars 121.53 billion; at US dollars 1,600 per troy ounce translates to US dollars 162.04 billion

At current oil and gold prices and assuming China only uses gold flow and not stock to fund its oil imports, the People’s Republic can only pay for about 12 per cent of its oil imports using its annual gold mine production. Moreover, even if China was to buy 100 per cent of the gold mined in the world (it cannot), it would still only be able to pay for approximately 57 per cent of its oil imports in gold.

Lest we ignore the obvious, buying the equivalent of annual global gold production neither solves China’s problem of having a large commodity related import bill nor does it end its reliance on US dollars.

China needs a 9x re-rating of the gold-to-oil ratio for the oil-for-gold structure to be a wholesale solution to its oil-liquidity conundrum. Unless the cost of mining gold relative to the cost of extracting oil increases nine fold, there is little to no economic basis for such a re-rating. For this reason we doubt that the oil-for-gold structure is the most feasible solution to the problem. Moreover, it does not seem, to us at least, a sound thesis for investing in gold.

For those who can, investing in Chinese government bonds, we think, is a better bet than investing in gold in expectation of the gold-to-oil ratio re-rating 9 times higher.