The gold bug religion is not for the faint of heart. In the past month, gold soared within $11 of the $1000 mark, only to reverse and plunge more than $100. In the process, gold violated the June low and is precariously close to the cliff's edge at about $850, the low in early May. Gold fever is very catching when the metal soars, but real conviction comes at a price.
I believe gold is likely to go lower in the short term, now that it's breaching critical support levels. A lot of people who thought they had conviction about gold are panicking, especially the ones foolish enough to buy on margin.
Much of this is driven by profound ignorance, supposing that gold is dependent on high oil prices, or that gold must trade as an inverse proxy of the USD or the EUR or other meaningless paper markers. Most professional gold traders are like the Fed and Treasury: They don't know what they're doing. They're still following the old formulas that worked in the past, but the past was then and this is now.
The sell-off was exaggerated by "black box" program trading, wherein the technical speculative longs gave themselves a thorough drubbing by letting market manipulations whipsaw them out of sound trades.
A lot of weak hands barfed because they had convinced themselves that gold simply could not breach the May low, that reaching the $850 level would indicate a massive failure and the end of the gold bull market. When the gold elevator seemed to be heading for the basement, they lost their nerve and jumped off.
I saw this same thing happen last August. Widely followed asset manager Jeff Clark saw gold break to $650 and said, "That's it! Close out all your gold mining stock positions now. Our technical stop-loss has been hit!" (I'm paraphrasing; he used a lot more words.)
At the time, I said to myself, "You're nuts, Jeff. The trade hasn't even started yet. The FOMC is about to meet and the fed-funds futures markets show a 100% chance of a big rate cut. The dollar will tank and gold will recover." Everyone knows how that turned out. Gold didn't just recover to $730, it soared another $300 or so while the USDX began its plummet towards 70. And of course, the gold majors broke out of their doldrums.
The primary trigger in this present gold whipsaw is the falling oil price. Professional traders and analysts have got it in their heads that inflation is caused by high energy prices. I see this myth in print almost every day. The truth is that gold tracks the growth of worldwide money, and its velocity curve is a direct function of the level of fear in the markets. But most "experts" still think the oil companies cause inflation somehow by raising the price of gasoline at the pump. Thus, when oil sells off, they buy dollars and sell gold because, Hey, oil is falling so inflation is over.
I can already hear the frightened sheep bleating. "But the dollar is getting stronger! Look at Forex, you idiot! The dollar is hammering the GBP, the EUR and the JPY! How stupid can you be, GG, you deaf, dumb and blind wart hog?!"
There's no need to be insulting. I can be plenty stupid, but not about this. Always, always, ALWAYS remember that Forex numbers are only paper measured against paper. And the people who issue the paper can always manipulate it, and they do so all the time, quite openly. If you watch the charts, you knew that the pound and Euro were grossly overbought and ready for a sell-off. It was easy for the bankers to orchestrate the move, as they had already publicly stated their intention to do so. Currency traders were on high alert.
A few days ago, I posted links to articles in which the various central bank authorities described their constant efforts to "manage" the value of their currencies through inter-bank operations. "Manage" is just banker-speak for manipulation. For years the Bank of Japan has artificially suppressed the value of the JPY for trade purposes through the Zero Interest Rate Policy (ZIRP) and the current .52% benchmark rate. Both Chinese and Japanese bankers have cooperated with the Fed to artificially inflate the exchange value of the USD by selling RMB and JPY and buying USD. It's in their interests to do so because it props up the value of the roughly $1.5 trillion in U.S. Treasury bonds they hold in their reserves, and at the same time leverages the purchasing power of U.S. consumers who buy Chinese and Japanese exports.
That said, I also think this apparent gold breakdown is a bear trap. I doubt it will outlast August, or not by much. The plunge in the gold price has come perfectly timed to ignite Indian demand ahead of Diwali (the harvest & New Year festivals) and the wedding season. Indeed, Indian gold purchases are already ramping steeply as gold gets cheaper:
http://in.biz.yahoo.com/080808/137/6wc53.html
The trouble with manipulations is they're only effective as long as the central bankers are willing to keep the artificial pressure on. They can't do this forever, because (a) it costs money, and (b) it has undesirable side effects, especially if it goes on too long.
How does it cost money? Japan has to buy dollars, which they do not want to do, as they have too many of them already. Indeed, over the last two years Japan has unloaded enough USD bonds to put them in second place behind China as leading holders of U.S. debt. They wanted out of dollars because of the multi-year slump through which the Greenspan rate cuts dragged the buck. Now the Bernanke Fed is reenacting the rate-slashing, and the Japanese are being forced to buy what they'd rather sell. China is in the same fix. Beyond the initial purchase cost of paying for a weak currency with a stronger currency, there are the "quasi-fiscal costs" (a negative real yield) and the opportunity cost of tying up funds in a non-performing asset.
The talking heads are giving us two different stories, and I think both of them are wrong. One bunch is saying that we are heading into deflation because money in the form of debt is being destroyed at a tremendous rate as structured credit vehicles unravel and default. This sounds right at first hearing, but it doesn't take into account the fact that hardly any of the securitized-debt bonds are actually being allowed to default to true market value. Much of this debt is being held on bank books at inflated values with borrowed loan-loss reserves parked against it. That's not debt destruction, that's cold storage. The rest is being held on the Fed's books as collateral for giant loans of Treasury bonds--more cold storage. That portion is not destroyed until the Fed writes it off or returns it to the banks that placed it. Who knows when or if that will happen?
The other talking heads are telling you that we're headed for hyperinflation because the Fed is printing credit at a spectacular rate and all that new money will inevitably gush into the marketplace in a tsunami that washes commodity prices sky-high. That also sounds good until you look at the details. Where is the Fed issuing all this credit? At your local grocery store? Nope. At the Exxon station, or Sam's Club? Not yet, anyway.
The Fed is creating the vast bulk of the new credit in one limited venue. That venue comprises the various term lending facilities, and those are available only to huge commercial customers, namely the 20 bond-dealer banks and a few "primary dealers," which means a select group of securities dealers who are the special friends of the Federal Reserve, also known as the Too Big to Fail Club.
What are the bankers doing with all those hundreds of billions of dollars? Well, I can tell you this: They're not down at Call Girls-R-Us, buying time with Eliot Spitzer's old "girlfriend." They're not filling up the tank on the Bear Stearns-mobile. That money is parked and immobile. It's locked down on the balance sheet in the category of loss reserves.
Remember, the only reason the Fed began loaning T-bills against junky mortgage bonds is because the banks were completely out of capital. They're still out of capital, net $160 billion in the hole as of the latest Fed report on depositary institutions. That's why banks are so busy cutting credit lines and not approving mortgages. They're still capital-impaired, and it's not getting better yet. In fact, capital-impairment can't resolve itself until the banks stop writing down and start charging off.
In short, the true effects of Fed credit enhancements won't be known until the Debt Bubble has been allowed to pop and utterly deflate, which is the very last thing the Fed wants to happen.
This is why real estate prices and stock prices keep slipping, and that looks like deflation. On the other hand, consumer staples remain near historical highs, and that looks like inflation. I think the Fed will attempt to get credit moving, not just to the commercial banks, but through them and to the consumer so that economic activity will pick up and pull out of a recessionary tailspin. I don't see yet how they will do this, but we're sure to witness even more "Fed Stunts You Never Thought You'd See" in the coming months. Deflation is the Fed's ultimate nightmare.
The term lending facilities will ultimately drive inflation at multiple levels, but the time frame is obscure. Both the size and duration of auctions is being extended, but only as banks continue to require more capital infusions to offset derivative losses. My belief is that the more immediate risk is the giant pile of U.S. dollars in foreign reserve accounts around the world. Dollars parked in International Monetary Reserve accounts are sleeping dogs. If the current owners kick those dogs awake and send them back where they came from, U.S. consumers will get their butts chewed off by the little mongrels--and there are trillions of them.
http://www.imf.org/external/np/sta/ir/8802.pdf
