Macroeconomic fundamentals underpinning the bull market in gold remain in place.
I am certain that the recent flattening of the trend in gold prices amid a weakening global economy and ongoing turmoil in credit markets has people spooked. Even a certain named investor has turned bearish on the yellow metal highlighting the decoupling between gold and oil prices. Nevertheless, markets are made on differences of opinion, so allow me to share my (more sanguine) view of the situation.
Intuitively, as a currency in limited supply, gold should trade off of supply and demand dynamics for paper currencies. However, what is more striking is that, relative to hard assets, it is the supply of paper currencies that leads demand for them (in hard asset terms) because of the lead-lag relationship between liquidity and inflation. Put another way, printing money leads to inflation, and for a rational investor to hold something that depreciates (loses value in real terms) is simply undesirable.
On the liquidity front, with the exception of Kansas City Fed President Tom Koenig (more on this in my next post, which you can find here), Fedheads have hinted on numerous occasions that policy will likely remain accommodative for an extended period of time in order to engineer a return to trend growth. These statements, coupled with an ongoing moderation in the pace of the global economy, will also likely result in a bias towards easy policy and/or additional measures to boost liquidity at the world's other major central banks.
What is clear is that there is a chronic dysfunction in the world's credit markets, and the longer it lasts, the more sectors of the economy it permeates, which ultimately means that more money will have to be thrown at the situation to fix it. Up to now, the surprise has been on how long it would take for the U.S. to recover. In 2006 the bet was that things would pick up in ’07. Last year, expectations were for a rebound in Q3 of this year. Now, 2009 appears to be the magic number.
From this, it is a good bet that the credit crunch is not over (although I would infer that markets are less rattled than a couple of months ago), meaning that the risk of further infection remains. I am sensitive to the notion that if left to resolve itself without human intervention that the massive deleveraging of the global financial system is deflationary, but history has shown that humans pick reflation over deflation, perhaps because of our finite life span**. In sum, the forced printing of money is not over… in fact it may just be getting started. Score one for gold.
Because the price of gold is (arguably) set by financial markets, then it is not necessarily inflation that matters, but inflation expectations. At present, expectations in the world’s major economies appear to be well anchored. Break-even long-term bond yields (meaning what the market expects inflation to average beyond the next couple of years) are just over 2% in the U.S. and somewhere between 2.5% and 3% in the euro area. As highlighted by both the ECB and the Bank of England on Thursday, risks are obviously to the upside (more on global central banks in a post next week).
With long-dated commodity futures holding firm and still trending higher, there appears to be a dislocation between the commodity and fixed-income markets. Add on robust demand from emerging countries that want to spend on infrastructure because their people are fed up of living in poverty, and seemingly daily announcements of shortages and the inability of producers to boost supply on a sustainable basis. If bond yields are a combination of inflation protection and growth, then I fail to see how earning 4% on Treasuries is adequate compensation for this situation, which leads me to the dollar. The dollar cannot rally for long given the structural deficiencies in the U.S. and inflation has bottomed on a secular basis. Point final. By the way, two more positives for gold.
Now that I have outlined the secular situation for gold, it is worth taking a look at shorter-term dynamics to gauge whether gold is headed higher now or later. I have no problems with lofty forecasts, but those that call for stratospheric prices now are just trying to get people excited to make their prophecy come true, so be careful. I am no quant wizard, but I make the following observations.
Technically, gold appears to be in an extended consolidation phase much like what occurred in 2006: 50% run-up, correction, consolidation, 50% run-up (see chart). Momentum has also reached the same oversold levels that it did in 2006, in the same amount of time. On the positive side, during both corrections, there was big volume in the final upleg, but reduced volume during the sell-offs, perhaps suggesting that people are still moderately positive. What will worry me is if gold breaks below $790 (last year’s support level). However, the macroeconomic factors which I have outlined above remain firmly in place, so for now, support should hold.
To conclude, I think that the outlook for gold remains bright, but caution that it may take a little while for the next upleg of the bull market to take shape. As always, the standard disclaimer applies: My posts are not endorsements to buy or sell securities; they are merely opinions on issues that interest me.
** Check out The Selfish Gene by Richard Dawkins for more reading on biology and behavior.
