Gold Sell-Off: There is Only One Question that Matters (DetlevSchlichter.com)
Wednesday April 17th, 2013
Last Friday I participated in a (very short) debate on BBC Radio Four's Today Programme on the future direction of gold. Tom Kendall, global head of precious metals research at Credit Suisse argued that gold was in trouble, I argued that it wasn't. So yours truly is on record on national radio on the morning of gold's two worst trading days in 30 years arguing that it was still a good investment.
I still think that what I said on radio is correct and even after two days of brutal bloodletting in the gold market and two days of soul-searching for the explanations, I believe that this is the only question that ultimately matters for the direction of gold:
"Has the direction of global monetary policy changed fundamentally, or is it about to change fundamentally? Is the period of 'quantitative easing' and super-low interest rates about to come to an end?"
If the answer to these questions is 'yes' than gold will continue to be in trouble. If the answer is 'no', then it will come back.
Reasons to own gold
The reason for why I own gold and why I recommended it as an essential self-defense asset is not the chart pattern of the gold price, the opinion of Goldman Sachs, or the Indian wedding season but the diagnosis that the global fiat money economy has check-mated itself. After 40-years of relentless paper money expansion and in particular after 25 years of Fed-led global bubble finance, the dislocations in the global financial system are so massive that nobody in power dares to turn off the monetary spigot and allow market forces to do their work, that is to price credit and to price risk according to the available pool of real savings and the potential for real income generation rather than according to the wishes of our master monetary central planners.
The reason why for almost half a decade now all the major central banks around the world keep rates at zero and print vast amounts of bank reserves is that the system is massively dislocated and nobody wants the market to have a go at correcting this.
There are two potential outcomes (as I explain in my book): 1) This policy is maintained and even intensified, which will ultimately lead to higher inflation and paper money collapse. 2) This policy is abandoned and the liquidation of imbalances through market forces is allowed to unfold.
Gold is mainly a hedge against scenario 1) but it won't go to zero in scenario 2) either. So far, I see little indication that central bankers are about to switch from 1) to 2) but we always have to consider the fact that the market is smarter than us and has its ears closer to the ground. What is the evidence?
Cyprus and EMU
Taken on their own, events in Cyprus were not supportive of gold, not because the island nation could potentially sell a smidgeon of gold into the market but because the EU masters decided to go for liquidation and deflation rather than full-scale bailout and reflation. Cyprus' major bank is being liquidated not rescued and 'recapitalized' as in the bad examples of RBS, Northern Rock, Commerzbank, or more indirectly -- via shameless re-liquification – in the case of Goldman, Morgan Stanley, Citibank and numerous others. The ECB's balance sheet has been shrinking over the past 3 months, not expanding. Depositors in EMU (and even EU-) banks are being told that in future they shouldn't rely on unlimited money-printing or on unlimited transfers from taxpayers in other countries to see the nominal value of their deposits protected. This is a strike for monetary sanity and a negative for gold. It should reduce the risk premium on paper money on the margin.
If this sets an example of where the global monetary bureaucracy is moving than gold is indeed in trouble. However, I don't see it. As I argued before, it seems more likely to me that Japan is the role model for where other central banks will be heading: aggressive fiat money debasement, a last gasp attempt at throwing the monetary kitchen sink at the economy. Additionally, the EU bureaucracy may not be as principled on the question of hard or soft money when the patient brought in on a stretcher is not a European midget like Cyprus or even Greece but one of the big boys, i.e. Spain, Italy or France, the latter having been the EMU's big accident waiting to happen for some time. Mr Draghi's phone will immediately ring off the hook. My sense is that even in Europe the days of 'quantitative easing' are not numbered by any stretch of the imagination.
Bernanke, the anti-Volcker
But the central bank that really matters is the Fed. Will we one day look back on the days of April 2013 as the moment an incredibly prescient gold market told us that Bernanke was getting isolated at the Fed, that people had begun to seriously tire of his academic stubbornness about the U.S government having a technology, a printing press, that allows it to print as many dollars as it wishes...blah, blah, blah..., and finally got the knives out and finished this undignifying spectacle of madcap dollar debasement? -- Of course, I don't know but I somehow doubt it.
Yesterday was the worst day in the gold market since February 1983. Back then gold was in a gigantic bear market, not because of what Goldman thought or said, but because Paul Volcker was Fed chairman and had just applied monetary root canal treatment to the US economy simply by stopping the printing presses, allowing short rates to go up and restoring faith in the paper dollar. Hey, 20 percent on T-bills, how is that for a signal that paper money won't be printed into oblivion! The important thing was that Volcker (and some of his political masters) had the backbone to inflict this near-term pain to achieve longer-term (although, sadly, not lasting) stability and to live with the consequences of the tightening. Today, the consequences would be much more severe, and there is also much less central banker backbone on display. Over the past two decades, the central banker has instead become the leveraged trader's best friend. Volcker was made of sterner stuff.
If the gold market knows that easy money is about to end, how come the other markets haven't got the news yet? Do we really believe that stocks would be trading at or near all-time highs, the bonds of fiscally challenged nations and of small-fry corporations would be trading at record low yields, if the end of easy money was around the corner?
To justified the lofty valuations of these markets on fundamentals, one would have to assume that they no longer benefit from cheap money but instead have again become the efficient-market-hypothesis' disinterested, objective, reliable, and forward-looking barometers of our economic future, and of a bright future indeed, in which apparently all our problems – cyclical, structural, fiscal, demographic- have now been solved, so that the central bankers can pack up the emergency tool kit and gold can be sent to the museum. -- Well, good luck with that.
The sucker trade
In the debate last Friday, my 'opponent', Tom Kendall, made a very good point. Tom said that what causes problems for gold was the 'direction of travel' of the economy and other asset markets. It is maybe a bit of a strange phrase but the way I understood it it is quite fitting: Equities are trading higher (in my view, mainly because of easy money and the correct expectation that easy money will stay with us) while bonds are stable and inflation (so far) is not a problem. In this environment, the gold allocation in a portfolio feels like a dead weight. For most investors it is difficult to stand on the sidelines of a rallying equity market. They need to be part of it.
I think that what is happening here is that Bernanke & Co, are enjoying, for the moment, a monetary policy sweet spot at which their monetary machinations boost equities sufficiently to suck in more and more players from the sidelines but do not yet affect the major inflation readings and do not upset the bond market. This policy is not bringing the financial system back into balance. It does not reduce imbalances or dissolve economic dislocations. To the contrary, this policy is marginally adding to long-term problems. But it feels good for now.
Bernanke is blowing new bubbles, and as we have seen in the past, it is in the early inflation phases of new bubbles that gold struggles. Equity investors are getting sucked in again, and the gold bugs may have to wait until they get spat out again and the Fed's cavalry again rides to their rescue, that gold comes back.
In any case I remain certain of one thing:
This will end badly.
Detlev Schlichter is an independent economic consultant who formerly worked at Merrill-Lynch and is now the author of Paper Money Collapse: The Folly of Elastic Money and the Coming Monetary Breakdown. See his website: DetlevSchlichter.com.