Why it’s Okay to still be Bullish on Gold: The Difference between Short and Long term

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Given the fact that the asset class of precious metals, and more generally commodities became the easiest pick for investors over the latest decade, we really shouldn’t be that perplexed with the idea of how quickly it has now been shunned by the masses. As the price of gold continues in a downtrend, the widely popular SPDR Gold Trust ETF is seeing its lowest levels since 2009. But since the final surge in the price of gold was driven by a herd mentality amongst investors to protect against a stimulus program so complex it was difficult to comprehend, it’s reasonable an asset class associated with fear and uncertainty became a safe harbour of capital. More recently though, what believers of gold and other precious metals learned is the price can go down as quickly as we saw it go up, and that’s not to acknowledge that gold was in a bubble, or by some analysts’ definition has entered a bear market, but perhaps instead, a short period of consolidation.

10 year gold

It’s not just because of my bias from being in the industry that I believe this Bull Run in gold is far from over. If the chart above illustrates anything, it’s that this market over the last ten years still looks rather healthy. Instead, there are some very distinct reasons why for the long term we can still be bullish on gold despite the noise we see here in the short term, and they are as follows:

  • – Outlook is for record low federal funds rate (interest rates) into 2016

  • – Taper of Quantitative Easing does not equate to tighter policy

  • – Global recovery still remains fragile as the fiscal health governments is no better off than before the crises

The outlook for interest rates along with the fact that any upward manoeuvre in policy rates still remains the upmost threat to economic growth is what has fuelled demand for real assets over the last few years. Furthermore, record low rates have fuelled a consumption binge in the world’s developed economies that now sees the general population saddled with record debt levels. And it’s simple; in order to reign in household imbalances individuals must either save more and consume less, or grow their incomes at a faster rate than their debt. The premise now that we live in a global economy with sub-par 2 percent economic growth is what will constrain individuals and force policy makers to keep rates low for the foreseeable future.

And it’s the Federal Reserve and other central banks that offer the guidance of low rates that will continue to stimulate the economy. We are beginning to learn, and soon accept that the unconventional methods of quantitative easing have run their course. And given the improvement in the US labour market is far less than the US central banks hopes for at this point in the recovery, it’s even more evident this pending policy shift speaks more to the efficacy of its efforts than its arguably somewhat satisfactory achievements.

But finally, and this is the one point surrounding gold that almost everyone seems to have forgotten as of late, and that is the debt burdens of government that seemed to be of paramount focus during and before the great recession are no longer relevant. Paradoxically, they are actually worse than when we entered this crisis five years ago. Despite the efforts of massive stimulus programs from just about every western power, the worlds developed economies actually haven’t returned to full strength, and are even more burdened as a result of the stimulus.

And that quite simply is what kick-started gold’s run back in the beginning of this century. It wasn’t quantitative easing. And for over two years between July of 2004 and November of 2006 interest rates actually went up. But a mix of the aforementioned factors paired with the ineffectiveness of government that opts to devalue their currency in order to attempt to stimulate growth is what will eventually turn around this downturn in gold, and fortunately for some investors has created the buying opportunity of the decade.

Why the Taper Will Come

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“Continuing assessment of the efficacy and costs of asset purchases might lead the Committee to decide at some point to change the mix of its policy tools while maintaining a high degree of accommodation.”

-Minutes of Federal Open Mark Committee October 29-30, 2013

The above text is the most important aspect of the most recent Federal Open Market Committee (FOMC) meeting that took place between October 29 and 30. The text is in no way novel as the sustainability of this economic stimulus program has always been of concern, and thus examining its long term benefits and consequences continues to be the focus of Federal Reserve officials. However, moving past analyzing the efficacy or cost of the program, it is the end of the above quote that is most telling. And that is that the misconception by the financial media of tapering Quantitative Easing meaning that the Fed is attempting to make their policy less accommodative. In fact to the contrary, it is not that their goal is to be less accommodative, but change the medium in which it is delivered.

In most recent months the newest term to be thrown around in the tool basket of Fed policy approaches is forward guidance. Essentially, it is a central bank utilizing their ability to vocally influence markets by casting their projections on economic activity or policy interest rates. The most recent projections have the Fed maintaining their emergency low federal funds rate at a quarter of a percent or 25 basis points until the beginning of 2016. Similar to quantitative easing, where the fed acted as a backstop for the threat of illiquidity in financial markets, and acted to supress long term interest rates (something not typically within the conventional capability of central bankers), which gave investors’ confidence not only in the present, but also into the future. Forward guidance gives a similar message, and that is that policy will continue to be highly accommodative; we are just witnessing it in a different form.

The problem that we are learning with a program like quantitative easing is that it has seemed to run its course. Where the anticipation was that the fed would inject massive amounts of liquidity into the financial system, and in turn banks and other financial institutions would go out and lend and spur investment fell short. What predominantly occurred was these financial institutions sitting on massive amounts of capital earned a minimal interest rate parking funds with the Fed and without ever incurring any real risk. James Bullard, President of the St. Louis Fed and who is arguably one of the most creative thinkers with the US central bank even took to discuss the idea of a negative policy rate this week to create an incentive to lend those funds. And it’s because the mere idea of printing money is no longer sufficient as the policy becomes ineffective without the printed money changing hands.

And this is simply why the Feds taper, as has been argued in past newsletters, is inevitable. It’s not to be confused with the aspect of an improving economy as we are yet to witness that. It is the fact that this trick has gotten stale, and the Fed’s looking for another manner in which to accommodate. When Ben Bernanke began what was originally referred to as QEIII, every analyst warned of the central bank running out of policy bullets as the effects not on the stock markets, but the economy seem to be wearing off. What we very well could be witnessing is the actuality that QE has run its course. No question it served its purpose, and with a dysfunctional federal government we can hope for some form of support from the US central bank, but at the moment, the fed looks to be out of ammo.

Defining the Yellen Put

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If the Janet Yellen testimony before the Senate Banking Committee this week illustrated anything, it is that the transition from Ben Bernanke to the incoming chair of the US Federal Reserve will be seamless. It is the typical story of the US Federal Reserve being dependent on the data driven recovery of the US economy that will affect their asset tapering decisions. Unfortunately though, it has become a distraction as to shift investor’s concentrations away from the perils of unproductive fiscal policy (at any level of government) and instead focus on the financial markets, which for the sixth consecutive week saw the S&P 500 and Dow Jones trade higher.

The unfortunate realization or perhaps lack of realization is that central banks, led by the US Federal Reserve, will continue to be the only game in town, and that was the message Janet Yellen implicitly provided last Thursday. US economic growth sits at that inflection point of around 2 percent where we will still wait to see whether the economy is ready to reach former Bank of Canada and current Bank of England Governor Mark Carney’s coined term “escape velocity.”

But the biggest reason that the credit easing policies will continue is because of the lackluster inflation levels seen all around the world. Until inflation actually becomes a credible threat to the worlds developed economies, there is no pressure on central banks to begin tightening their policies, or even talk about it. This is especially true given the average inflation rate in the OECD developed countries has fallen from 2.2 percent in 2012 to 1.5 percent so far this year. And reports out of the European Union last week highlight that deflation was more of threat than inflation with October’s inflation numbers registering at .7 percent. That creates a major threat to the nations of Europe, where the risk of seeing prices decline will create yet another impediment to their recovery from a triple dip recession.

The other issue, however, with forecasted paltry inflation levels is what countries with low inflation are associated with, and that is persisting levels of high jobless rates and mediocre growth. For this reason alone, the world’s central banks continue their aggressive policies, but it does truly illustrate their positions between a rock and a hard place as any opportunity to spur or revitalize economic growth is jeopardized by an unwavering price level. As Mohammad El-Erian argues, central bankers in today’s world are only destined to fail because our expectations for what they can deliver is far too inconceivable, given the “the much-sought-after trifecta of greater financial stability, faster economic growth, and more buoyant job creation.”

So it is not so much that there is a responsibility among the central bankers to instill the prior mentioned trifecta of economic goals, it is rather the shortfall of elected policy makers that force us to rely on the independent institution of a central bank. And just as it was the “Greenspan Put” beginning in the early 2000’s that saw the Federal Funds Rate drop every time the economy hit a speed bump to the “Bernanke Put,” which commenced the greatest era of manipulation of the Federal Reserve’s balance sheet in order to stimulate the economy, investors now eagerly await what will be the “Yellen Put.” Whether its offered forward guidance of low interest rates into the unknown future, or perhaps quantitative easing continuing longer than anticipated, one thing is certain, and that is for this economic recovery to continue central bankers are still needed more desperately than ever.

The Future Fiscal Drain of Obamacare

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The current debate on Obamacare is not over whether the US needs a system of universal healthcare. That debate has passed, successfully. There was the act in congress, a 2012 Presidential Election centred on the topic, and it was upheld in the Supreme Court. It is instead on whether the Affordable Care Act (Obamacare’s official title) is satisfactory in providing this service of healthcare, or whether it will end up like other failing federal fiscal programs that create a long term burden on their economy. It has the potential to do that because of the individual mandate.

The individual mandate requires Americans to purchase health insurance or pay a tax penalty, and it is showing to be Obamacare’s Achilles heel. One simple reason is that on average, males between the age of 21 and 35 see a doctor six times over that time horizon. To that subgroup, there is no value in buying insurance. It’s not to say males 21 to 35 have no reason to purchase health insurance; moreover, the financially burdening decision to sign up for a plan becomes irrational when compared to paying a penalty tax.

The system relies on the premiums paid by the young generation. From a business perspective, the widest margins are in the instances of the young and healthy adults, whom are exactly the ones not eager to sign up for Obamacare. So as the President of the free world touts about individuals who were formerly denied healthcare due to prior or existing health conditions (because of a requirement in the law that prevents insurers from denying coverage), the fact of the matter is currently the majority of Obamacare enrollees are either Medicaid recipients or individuals with health conditions. These people would represent customers for insurers with quite narrow or even negative profit margins.

Simply put, it’s a law of averages. Everybody buys into the system to pay for the costs of those who will unknowingly require its services. But when the law, from the outskirts, allows individuals who with the highest probability of not requiring health insurance to simply opt out and pay a tax, its longevity becomes questionable.

This leads to another shortcoming with Obamacare. The way the law is structured, excess costs incurred by the private insurance companies in some instances may be recovered from funds by the federal government. For example, according to an article in the Wall Street Journal this week, if insurers underestimate costs, they can be recovered from the Federal Government. That is one way to minimize the risk to insurers; however, back to the original problem, should Obamacare inevitably fail to attract sufficient healthy individuals to subsidize the cost of the more demanding ones in terms of health benefits, premiums will go up in future years as the costs of the program increases.

The individual mandate was the biggest political stalemate when passing the act because conservatives did not believe the government had the authority to force someone to buy a good or service, but the law passed. Inevitably, it is a tax. It costs Americans more via their insurance premiums, or smaller wages as insurance is provided by their employer. The service in return for their tax dollars is healthcare.

Add this to the list of other underfunded American entitlement program.

A Dollar Tug of War

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A little over a year ago when the world was discussing the realms of currency wars and central banks purposely imposing policy in order to devalue their exchange rates with trading partners, it was the policy makers that argued that their approach was directed domestically, and a weaker currency was simply an indirect consequence. As long as the policy intent was not, for example to weaken their currency, or to better the country’s respective terms of trade by cheapening their exports, it was deemed acceptable.

Today, however, we are seeing the other side of that coin as western central bankers once again look out for their respective countries best interest, and in an uncoordinated approach adjust their monetary policy and stimulus. And it’s the worlds emerging economies, who were the engine of growth for the global economy as it climbed back from the worst recession since the Great Depression, that are feeling the pain.

It was only by coincidence, not by design, that central bankers around the world coordinated policy in order to spur economic growth. It prompted fears of currency wars or a “race to the bottom” in terms of devaluing their exchange rate. I think it’s clear now that did not yet happen. But if the tremors we are witnessing in currency markets over the last few days have illustrated anything, it’s that nothing destabilizes risk assets like the boisterous equity markets of 2013, more than uncertainty and instability in foreign exchange markets. And that’s exactly what’s to come as the world’s central banks once again operate in this unilateral non-structured fashion.

Over the course of the last week we saw action from central banks all over the world in attempts to stabilize their financial sectors. As the markets perceive the United States and the US Federal Reserve to be tightening their policy by altering their stimulus and decreasing their bond purchases by a successive $10 billion per month, the emerging market economies have no choice but to follow suit. It’s simply a stronger dollar attracting capital and foreign investment back towards the US, and other advanced economies. In the last week, countries like Turkey have had to raise their key policy interest rate from 7.75 percent to 12 percent in an emergency meeting. Although not as drastic, South Africa and India raised their rates also. And this doesn’t discredit that the home grown problems some of these countries already face may be the root cause of their suffering; moreover, a strengthening US dollar only acts to exacerbate their problems.

It’s almost paradoxical though how emerging economies through the efforts of the G20 were relied upon to fuel a recovery for the industrialized nations of the world. Many countries saw their exchange rates significantly strengthen against the US dollar, with Brazil being the textbook example as the Real appreciated by as much as 48 percent. No questions this strangled their export sector, especially given they represent resource based open economies which thrive on strong international markets. But now, a rift if being created as no consideration is yet to be given from the western world. A dollar tug of war is creating a global imbalance. And what’s surprising is that with a strengthening dollar, we are seeing the rebirth of the safe haven characteristics of gold.

Only in periods of extreme turmoil do we see gold and the US dollar trade higher in tandem. And that’s not to suggest that we have entered a period of extreme turmoil, but it certainly shows the potential for gold. To some extent it’s argued the industrialised nations can immune themselves from an emerging market crisis; nonetheless, periods of economic uncertainty have always been favourable for gold. That’s when insurance is needed more than ever. Alternatively, a weak US dollar also bodes well for the yellow metal. I don’t want to attempt to forecast a crisis, but this tug of war, juggling act, or whatever we want to call it is what will see gold bottom in 2014.

Triple Top

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Dennis Gartman on CNBC earlier in the week said this would be the most boring FOMC statement from the Federal Reserve this year. He was correct.

The Fed released a status quo policy announcement on Wednesday that was a stark difference from the fireworks created by their prior September statement and press conference. The Fed opted to keep their asset purchases via Quantitative Easing unchanged at $85 billion a month to be split between US Treasuries and Mortgage Backed Securities. The new consensus for the inevitable Fed taper has been pushed back to March of 2014, and with that the price of gold did a triple top at 1,360 USD per ounce, and then headed lower to finish the week, as the metals market once again looks to be under pressure.

Jon Hilsenrath, economics editor for the Wall Street Journal best summed up the uncertainty about when we will see the Fed begin to taper; “it’s anyone’s best guess.” And this relates to understanding how the US central bank operates and makes their decision. Every policy announcement or statement, and thus change in policy direction is decided upon by quantifying the most recent economic data. So as Hilsenrath explains, predicting when the Fed will taper is the equivalent to forecasting GDP, because without knowing how the economy will perform, it’s impossible to set a timeline for the Fed’s decision-making process. Furthermore, with the manufactured uncertainty and headwinds to economic growth created by the US government in Q4 of 2013, forecasts become even less reliable.

What we have seen in the markets though, in reaction to the US Federal Reserve and the announcement of continued easy money policies, is similar to what we are witnessing in the overall economy, and that is that they seem directionless. When 2012 seemed like a mediocre year for economic growth, and analysts were looking for the pickup in 2013—that too did not exactly come to fruition. Instead, what prevailed was more of the same tepid growth levels restrained by uncertainty relating to central bank and government policy.

Without trying to forecast GDP, it seems inevitable the Fed will begin to taper asset purchases sometime in 2014, which is encompassed in the price of gold. And there are two strong supporting pieces of evidence for why this taper will come. Firstly, each US Treasury auction in the second half of this year has seen the Treasury department cut the number of bonds they are issuing to the market. Second, sequester budget cuts, and then constrained budget negotiations going into the New Year force austerity measures on US government spending. With a diminished supply of Treasuries going to market, nor the same level required to finance their deficit, the Feds involvement in the market thus becomes limited. Without the supply of newly issued government debt, the Fed does not, and will not need to be as an active of player.

Looking at the price of gold then heading into the New Year keeps with the short term bearish outlook. The problems with the US government debt aside, gold has become out of favour; therefore, excess selling in the market will keep downward pressure on prices. Moreover, even as the market is in search of a bottom, there is still reason to see higher prices in the years ahead. The US government’s inability to control their debt load is what keeps the long-term outlook bullish. We can look for strong economic growth to allow the issuer of the world’s reserve currency to manage their debt load, but likely it will be inflationary policy which attempts to keep their debt intact, and that ultimately will drive the price of gold to new record high prices.