Tuesday, 16 April 2013

Barbaric times for the barbarous relic

What has been the cause of the flash crash in gold since Friday? On the face of it the three legs of the gold bug’s stool ought to be stronger than ever.     

Cyprus has provided the first concrete evidence of deposits not being safe in nominal terms though the deposit levies that were eventually restricted to two banks and deposits of over €100,000.  That surely ought to make investors seek physical stores of value like precious metals.   

The longer lasting driver of gold’s value, negative real interest rates seem set to continue. Indeed with Japan’s determination to use extraordinarily aggressive means to meet an inflation target of 2% per annum that would imply that they will be joining the negative real interest rate club too.   

This leads us on to the third leg of the gold bugs’ stool: currency debasement.  Japan has indicated it will be running the printing presses (or, less emotively, “doubling the monetary base”) for at least the next year and, in reality, probably well beyond.   

Upon closer inspection, two of these trends have seen modestly negative developments.   
The Cyprus debacle turned from gold positive to gold negative following the news that the ECB was putting Cyprus under pressure to liquidate gold reserves in order to meet sovereign debts.  Cyprus’ gold reserves are modest in the context of the overall gold market and yet the implication of new supply seems to have made a jittery market very nervous indeed.  The implications are that other gold holders might be pressured to follow the same path, most obviously Italy which has nearly 80 million ounces of gold – 8% of global central bank holdings.   
Furthermore the pendulum of central bank focus may well have swung towards easing in Japan but there were tentative indications that it would swing back towards tightening in the US.  This is important because it is the dollar price of gold which everyone watches like hawks.  Ironically on Monday the gold price in yen performed even worse than the gold price in dollars as the yen rallied on risk aversion – a trend which remains in place even after the Bank of Japan’s policy switch.  Over the longer term, gold in yen has remained a profitable trade fitting the negative interest rate thesis.   
Last week’s Federal Reserve Open Market Committee (FOMC) minutes discussed the possibility that the current rate of asset purchases might be tapered during 2013.  Various Fed members have discussed removing accommodation, only to be quashed by Chairman Bernanke’s promise that the Federal Reserve will continue to provide accommodation as required. The appearance of such statements in the carefully crafted minutes was sure to grab attention.   
We don’t see that tapering taking place. If anything the recent economic data have argued against the removal of accommodation. Housing, employment and consumer confidence data have suggested a weakening over the last month.  Were asset purchases to be tapered this would not undermine the negative real interest rates argument which remain firm.   

So why the sell off? The reality is that gold has no easily appraisable fundamental value.  Rather its value is an article of faith.  We can see what newsflow would be helpful for the gold price and we can see what would be unhelpful but when all the potential converts have been converted, there is nowhere left to go.    

Another way of putting this is using Dow theory.  This suggests that an investment idea has three distinct phases. The first phase is the accumulation phase when astute investors buy assets before they have become popular. The second phase is the public participation phase when the idea gains widespread acceptance and price gains accelerate.  The final phase is the distribution phase in which the astute investors sell to the late comers.   

Part of the bear’s case is that gold is the ultimate greater fool asset. We cannot gauge where the demand will come in because any investor buying does so only on the basis that somebody is willing to pay a higher price for the same asset at a later date but still based on the same underlying economics. Industrial metals by contrast have a floor when their necessity for economic production meets their marginal cost of production.   

The question which haunts gold investors is where does this cycle end? How will we be able to decide the point at which to sell to the greater fool?   

Now consider the recent history. We have seen strong gold newsflow for some months now:

  • On 2nd August 2012 we heard Mario Draghi announce the Outright Monetary Transactions programme – wrongly assumed by many to be some form of quantitative easing but rightly assumed to open the door to potential monetisation of eurozone government debt.
  • 13th September 2012 the FOMC announced it would start buying $40bn per month of Mortgage Backed Securities with printed money until further notice.
  • 12th December 2012 the FOMC expanded this programme to include $45bn of treasuries.
  • Added to which we had the promise – eventually met – of more stimulus to come in Japan too.
For gold to have laboured during such a period of bullish newsflow we have to assume it has lost some of its lustre.  So could this be the end of the bull market? The question now is whether the fundamental support will return.     

Physical buyers (like Indian jewellery demand) will wish to take advantage of new lower prices but tend to do so only once stability has returned.  Algorithmic trend-following hedge funds are likely to buy only once an uptrend is established. Central banks may be buyers in the physical market, however, their motivation is diminished by a reduced pace of foreign exchange reserve accumulation and the potential for gold assets to be seen as a potential fiscal funding source (this last point is unlikely, but possible).

We spoke to an investor from a very large asset management firm this morning who was buying following the fall – that is important as it is that type of investor who needs to restore order to the gold price and the negative view recorded in these notes will not change until stability has been found. 

I asked how he values his holding. The answer was an acceptance that you can’t.  He made the distinction between the journey and the starting point.  Negative real interest rates tell him he’s walking in the right direction but the sentiment-driven nature of gold means he doesn’t know whether he started in the right place.  That makes sense but the risk is clear.

Guy Foster
Head of Portfolio Strategy

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