Another Bullish Signal for Gold

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The Financial Times reported this week that central banks around the world are in the process of repositioning their portfolios as they pare back their exposure to US treasuries. They are doing this ahead of the US Federal Reserve ending Quantitative Easing (QE) this fall. Their rationale is that without the US Fed acting as the biggest single buyer of US government debt, excess demand for US treasuries will not be absorbed by the market at elevated prices, and thus will lead to higher interest rates. This should insatiably create a demand for gold, and the demand is from those that need to hedge exposure to US currency and US debt.

And so continues the threat of financial instability for global markets. Contrary to this though, the theme on Wall Street for the last few weeks has been on the abnormally high reported levels of investor complacency. This is gauged by the VIX (commonly referred to as the fear index) touching its lowest level in seven years, which was right before the financial crises of 2007. And this is exemplified by the fact that the major US indices have not made a move one per cent or wider in either direction in a single trading session in the last two months. To some, this is unsettling and continues to prompt calls for that overdue correction in equities.

But looking longer term or perhaps examining the implications of what a diminishing appetite for government debt by the world’s largest money managers means is what is a greater concern verses a lull in the markets. Tighter monetary policy is prompting central bankers, pension funds, and large scale investors that traditionally steer towards fixed income to allocate more capital to riskier assets such as equities. This chase or reach for yield, that many of the world’s brightest thinkers have precaution of is taking place. Riskier assets, and at times less liquid assets will have trouble offering the consistency and performance that some of these funds, like pensions, seek to achieve.

The other caution though that stems from this is the potential of these large scale investors losing the flexibility of their liquidity. Arguably, this would more be a threat to the stability of global markets, but according to the IMF, as 62 percent of all central banks investments were held in dollar based assets last year, it was undoubtedly the utility of the greenback as the world’s reserve currency that offered this convenience. The uncertainty going forward is determining the effect of the end of the dominance or reign of the dollar.

And this is again where precious metals play a role. The greatest risk to financial markets is how the US treasury market preforms when its biggest buyer, the Federal Reserve, is no longer in its role as a never ending buyer of US debt. It in part served this role in order to support a market of suppressed long term rates. The belief is that the demand and rush for equities will keep their prices trading higher as all types of investors continue to raise their exposure to risk assets. Unfortunately, this continues to tell a story of the stark differences between the financial markets and the underlying economy.

One will have to budge.

Sizing Up Gold’s Rally

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Gold had its best single day performance since September of 2013 on Thursday of this week. It begs the question, what contributed or led to the 50-dollar rally as it was not triggered by a single piece of economic news, geopolitical action, or policy announcements. One thing that is clear, however, is there has been a shift in investor sentiment and speculators no longer feel as comfortable with their short positions in the futures market. The advances on Thursday, made largely on the back of technical trading confirm this.

Wednesday brought the typical FOMC announcement, to which gold coincidentally has become accustom to not react to. It was perhaps Janet Yellen’s comments during her press conference later on Wednesday that pre-empted the weak dollar trade that in turn was positive for precious metals. Despite the Fed continuing their pace of tapering their monetary stimulus, it was the outlooks for the Fed Funds Rate that were analogous to comments from the IMF earlier last week, that low rates will ensue until at least the beginning of 2017.

The closest piece of contradictory evidence to this is that North American economies, particularly the US and Canada, are beginning to see signs of inflation. Still nowhere near levels that would prompt policy response as of yet, but it’s been the lack of inflation that’s been the concern of both Bank of Canada and the US Fed, thus these drastic upticks have caught their attention. To give context, in the US, core inflation has been 2 per cent or above in 10 of the 65 months since the recession of 2008. A few consecutive months like we’ve seen certainly don’t make a trend; it’s the fact that key components like rising food and energy prices could very well be sustained.

And it is the rise in energy prices, triggered by geopolitical concerns that have been another positive for gold. Tensions around violence in Iraq have investors worldwide keeping a close eye on crude oil prices. As crude prices elevate to higher levels, consumers face higher energy costs and that means less expenditure elsewhere. Gold once again is participating in a fear trade, which history tells us in not usually sustainable for the market on its own, but paired with other factors could be a different story.

The materialization of an increase in the rate of inflation (which investors who questioned the Feds experimental policies have been waiting for since the onslaught of quantitative easing) provides support for metal prices in here. The question becomes will it last, or once again be more transitory in nature.

It’s difficult to try and forecast this rally and the strength and breadth of it. But one thing is for sure, the move in gold this past week was impressive, and if conditions continue to manifest as they were, this rally could be for real.

As per usual, it’s a wait and see game.

Europe’s Deflation Fear

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The European Central Bank, as expected, unveiled a shotgun approach last Thursday to uplifting the Eurozone’s stagnating economy. The story with the ECB was that all they had to do thus far was wave their metaphorical policy weapon without every firing a bullet. By acting last Thursday, investors should question whether Europe’s problems are just beginning, or if it’s just Europe’s turn to embark on a beggar-thy-neighbour policy through euro devaluation.

It’s too early to tell, and perhaps too bold to call for Europe to enter into a deflationary spiral. What we have seen occurring is a period of disinflation, which is seen when the inflation rate slowly gravitates towards zero. This has been the increasing challenge for policy makers as it is the lacking demand of a healthy economy that is seeing the price levels move lower. But this is a problem of the global economy in the manner in which central banks have operated, particularly over the last six years.

The strengthening euro, whether it’s a result of unconventional monetary stimulus from the Federal Reserve, Bank of England, or Bank of Japan, is the reason for Europe’s sluggish economy. As other economies boosted stimulus measures and coordinately weakened their respective exchange rates, they are essentially exporting their lower prices to their trading partners. As their goods are now priced cheaper in foreign markets they typically saw that pick up demand which saw their inflation rates track marginally higher. Eurozone nations and businesses, as we know, faced the consequences of importing lower prices from their trading partners at the result of their relatively strong euro. Following Thursday’s announcement, if the ECB can be successful this is soon to change.

The measures implemented by the ECB on Thursday are their best effort to devalue the euro. Akin to the United States when the Federal Reserve expanded the level of accessible credit in their financial systems, there lacks the demand for those funds. Monetary Policy can create the right incentives for borrowers to want and have access to capital. It cannot, however, make the small and medium sized businesses that fuel the economy take on debt, invest in machinery, equipment, and technology, and hire employees.

The ECB’s main measures were directed at their financial institutions. The first was lowering their deposit rate to negative territory to create a disincentive from banks leaving funds with the ECB overnight. As of late, however, European financial institutions have slowly decreased the level of deposits left with the ECB. As well, Mario Draghi, President of the ECB announced changes to their Long-term refinancing operation (LTRO). And again, the theory behind banks being able to lock in financing for near zero rates for up to five years creates great incentives for borrowers, but the dilemma remains whether or not they will be utilized.

Among many of his great quotes, Yogi Berra famously said, “in theory there is no difference between theory and practice. In practice there is.” The theory is that the recent steps taken by the ECB should create the right incentives for participants in the Eurozone economies. The practice is what’s to come, but the uncertainty is whether Europe will get a turn at the table in the beggar-thy-neighbour global recovery.