December 2013 - Border Gold

“The markets can remain rational longer than you can remain solvent.”

-John Maynard Keynes

It might have gone against the conventional wisdom to see the markets trade higher on the basis that the US Federal Reserve will begin, come January, to be less accommodative to the US economy, but it’s not exactly as if the markets have had a perfectly rational last few years. Amidst one of the shakiest recoveries from the greatest recession to plague the US economy since the Great Depression, we continue to see equity markets trader higher as all the disbelievers missed out on the seventh greatest annualized gain in the American stock markets since World War II. No question, it was the US Federal Reserve’s influence on long term borrowing rates that bestowed confidence in American consumers, and nonetheless fueled this American recovery, but as the Fed begins to adapt their stimulus measures to adequately reflect the necessities of this continued recovery, we can be certain the party’s not over yet.

Ben Bernanke, in his final press conference as the Chairman of the US Federal Reserve, assured investors of one thing, and that was that the Fed will continue to adapt to the needs of the economy. And just as easily as they could trim asset purchases by 10 billion a month equally split between Treasury bonds and mortgage back securities, they could increase by 10 billion as well. But as we at Border Gold have argued in past newsletters, the taper of the fed’s asset purchases was very much an inevitable occurrence; moreover, it is absolutely not to be confused with the end of an era of easy money policies in the months and years to come.

And as the easy money policies will continue the biggest influence on the market will be near zero short term interest rates, controlled by the Federal Funds Rate. Offered in the form of forward guidance, Bernanke made clear in his policy statement that rates will remain low “well past the time that the unemployment rate declines below 6-1/2 percent.” And that low of emergency level interest rates will be the fuel to the fire for the markets. It makes sense for the stock markets to be able to trade higher, almost in relief to the fact the world’s largest economy is no longer so desperately in need of such extraordinary stimulus. But it is the caveat that the highly accommodative economic environment will remain in place.

As the Berkley Economist Barry Eichengreen phrases it, a reduction “by $10bn a month is best dismissed as a taper in a teapot… $10bn of monthly security purchases are a drop in the bucket for a central bank with a $4tn balance sheet.” And in fact, by Bernanke beginning the taper, he began the very seamless hand off to Janet Yellen to fulfill the role of an accommodative central banker. This is as the markets can now digest the milestone that a measure once dubbed “QE Infinity” has the possibility of coming to an end.

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A Note on Gold:

Following what was a supposed short covering rally with the rest of the market given the Fed’s decision to taper, gold immediately sold off heading for that June low of 1180 US/oz. Thursdays close on the Comex, below 1200 US/oz. was the yellow metals lowest in three years’ time. From a technical stand 1180 stands out as an important number, but as this market faces tax loss selling pressure going into yearend precious metal markets are giving an indication that they are in the process of forming a bottom in Q1 of 2014.

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It’s hard to avoid the topic of the beleaguered Canadian dollar given the swift move down we have seen against its US counterpart over the last six weeks. Just six weeks ago the Loonie was much stronger, roughly trading around 97.50 Cents US before the Bank of Canada abandoned what many referred to as their hawkish bias on their second most recent policy announcement. And by removing that reoccurring implication that the next move in interest rates was going to be higher and just simply waiting for the economy to pick up some steam, economist and investors took the withdrawal of that hawkish tone as an indication that next move in interest rates could just as likely be to the downside.

But rest assured, a move lower in interest rates is not in the cards from the Bank of Canada in the months ahead, and the despite the toll its taking on the dollar, we won’t see the bank change step. In fact, this most recent downturn in our currency is one of the most natural trade boosters we could receive. But there is no question that the Canadian economy is struggling to achieve the economic growth forecasts that many had been optimistically hoping for earlier in the year. However, it is still nowhere near sluggish enough for the central bank to re-enter (or arguably remain in) a sustained period of emergency level record low interest rates. And quite simply, it is the inability for the Bank of Canada to raise interest rates due to the inherent weakness in the economy, and that is the main factor driving the Loonie lower.

There are also two fundamental reasons though we are seeing weakness in our currency. The first has to do with the lack of inflation. Most recent data highlights the price level advanced by an annualized rate of a mere seven tenth of a percent in October. And the lack of inflation in the economy has two very simple implications. One is that low inflation levels are associated with more muted periods of economic growth. The second and relating to the lower levels of economic expansion is that the economy struggles to create jobs. But when you have the Canadian economy still averaging over 13,000 jobs created a month, it’s not yet a worry. For any serious credibility given to a downward move in interest rates, job growth would seriously have to dissipate.

The second reason we are seeing the dollar trade lower is to do with a deteriorating balance of trade. Particularly, the weakening demand we are seeing in the resource sector is equating to a waning demand to purchase those commodities. And as that sector of the economy has proven to be so pro cyclical with GDP growth, it can be expected that when the resource sector picks up again, and it will, we will see a renewed demand that is very supportive of the Canadian currency.

While examining the fundamental factors impacting the Canadian dollar these last few months, if these volatile financial markets over the last few years have illustrated anything, fundamentals, albeit important, can very much be trumped by the sentiment of investors. And the fact that Canada was the least dirty shirt among the worlds developed economies was what elevated our Canadian dollar above parity. In fact, beyond the fundamentals, the Canadian dollar almost carried an elite status because of the relative strength of our financial institutions following the worst recession since the Great Depression. In the moment though, the story is very much about the regained strength of the US dollar. Pair that with a central bank abandoning their hawkish views and we will see the premium in our currency dissipate.

The Inevitable Taper Part II

Looking at the Loonie