Swiss Votes…No

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In the wake of the Swiss referendum on whether the central bank should increase their allocation to gold, investors are tasked with the question, is the no vote yet another reason to be bearish on gold at present time. Voters clearly rejected the question of whether the Swiss National Bank (SNB) should hold at least 20 per cent of their balance sheet in physical gold, which would have lead them to the purchase of 1500 metric tons over the next five years.

Even though some gold bugs were clamoring on this vote as a reinforcement for responsible management of a country’s currency, especially in the wake of quantitative easing and rapid expansion of the monetary base in countries like the US, Japan, and potentially Europe, this vote was more about anti-EU sentiment and the euro’s influence on the Swiss Franc. In the near term, its certainly possible some noise or gyrations leads the market to react to the “No” vote and we may see prices trade lower, but it too remains consistent with a strong US dollar trend that is yet to see gold return as that safe haven asset.

Citibank’s Willem Buiter made headlines this week leading up to the vote as he strongly advocated for the “No” position. It shouldn’t really come as a surprise that like-minded academic economists believe in leaving the autonomy of central bank operations with the people who manage that institution and not subject to populist regulations. Especially because a central bank is in place to instil longer term views than perhaps myopic policy decisions witnessed in different levels of politics.

Buiter, however, did stress one key point that it’s important for even those in favour of the floor on gold reserves, and that is requiring a central bank to hold a minimum amount of gold ultimately decreases the values of those gold holdings to zero. As we know, gold standards ultimately fail. As the Citi Global Economist said, gold has been in a 6,000 year bubble, arguably making it the longest-lasting bubble in history, but that’s not really a surprise. A bubble is anything that is priced above its intrinsic value.

The intrinsic value of gold is something that economists have been trying to put a mark on for years. The typical arguments when comparing it to another financial asset are it doesn’t produce cash flow, and not providing any right to future earnings or repayment minimize any fundamental value it might have. What we do know about gold is that history has proved it to be a commodity that is tied to the global monetary system, and its limited supply and negative correlation to the world’s reserve currency make it a popular hedge when diversifying a portfolio.

Inevitably, the price of gold might be the longest bubble in human history, but if that is indeed the case, what will change that? The famous words of former US Federal Reserve Chairman, Ben Bernanke during a senate testimony were, “no one really understands gold prices.” That’s because how we value or price assets in today’s financial world doesn’t apply to gold. Gold is and always has been a hedge. Setting a predetermined or fixed allocation of a balance sheet to gold will ultimately devalue it because it takes that metal out of the market permanently, and the price adjusts. But gold’s flexibility and role in a dynamic investment environment, as we are in today has been proven over the life of its 6,000 year bubble.

Geopolitics Plays Interference

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It seems that once again the direction or trend playing out in the markets has been interrupted by geopolitical tensions heating up between Russia, Ukraine, and the Western powers. Precious metals finished the week on higher footing, with gold initially touching below 1,150 USD this past Friday morning, but going on to finish the day approximately 40 dollars higher just shy of 1,190 USD. The predicament for those who have been anticipating a bottom in the precious metals is determining whether or not this is simply just noise that will once again wash through and see the trend of a stronger greenback and weaker precious metal prices continue.

If weeks prior can provide any indication for what Russia-Ukraine tensions mean, it’s that they have led to unsustainable rallies in the metals market. The escalation of sanctions and threat of increased violence simply subside with time, and metals prices tracked lower accordingly. Thus, a suitable question becomes why does the market again react to similar events we have witness play out before if inevitably, time will pass and they will soon be forgotten?

For certain the liquidity of the gold and precious metal markets is one factor for the surge in prices as the relatively smaller market becomes a very quick and instantaneous hedge for the US dollars and risk assets. Short term investors or traders are less concerned about the price level of gold, but instead will go long gold as it exhibits its safe haven characteristics during these time periods.

Perhaps another reason though is the ongoing uncertainty surrounding the Russian economy. And although what we are currently witnessing with Russia is simply antagonizing tactics with Ukraine, the likelihood of escalation of sustained violence (or war) becomes more and more likely as their economy worsens. The Russian Ruble has depreciated 23 per cent against the US dollar over the past three months. Inflation becomes a huge issue for the Russian consumer with prices up nearly 8 per cent over the last year, and it is a trend that is likely to continue as the economy is extremely dependent of imports of food and agriculture as they are unable to substitute for what is inadequate domestic production.

As the Russian economy gets choked off from the rest of the world, and it’s the citizens that feel the brunt of the pain and suffering as their lifestyles adjust to a weaker economy that makes the majority of them worse off, options become limited. The uncertainty, which is very much priced into the market for Russian Rubles, and attracting a safe haven bid in precious metals, is how far into a corner is Putin backing himself, and what will be the repercussions of his actions.

And one potential repercussion becomes, as the media has been questioning, the likelihood of another cold war. Ongoing and increased sanctions with Russia are slowly cutting the economic ties to the west. It’s not without coincidence that the largest buyers of physical gold in the last quarter were Russia, Kazakhstan, and Azerbaijan. But all central banks in aggregate have bought gold now for 15 consecutive quarters. These are the long terms investors, and as one UBS analyst put it, in this kind of environment, “diversification would be deemed a logical outcome.”

Game Changer

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Friday was the best single day for gold in 14 months. This is as the markets seem to be playing a risk-on, risk-off tug of war with the US dollar. Despite the strong dollar trade dominating as we witnessed through the beginning of the week, it corresponded to the weakness in gold. The pullback we witnessed in the dollar into the close Friday stems from concerns over what may be the repercussions of a strong dollar for the US economy. Without doubt though, the trend is and has been for lower gold prices. A key day for the gold market was when we swiftly broke the 1181 USD support level, which the market had tested on three prior occasions beginning in June of 2013. As this was the first time the market has been sub-1180 since mid-2010, the physical markets were and are awash with new buyers.

As we learned over the last few weeks, despite the US Federal Reserve calling an end to their current round of experimental monetary stimulus, the game still lives on outside of North America. Although it certainly seems plausible that quantitative easing from the US Fed could make a return should the US economy warrant it, focus is what central banks are doing outside North America, particularly both the ECB and the Bank of Japan (BoJ).

The Bank of Japan shocked the markets into the end of last week as their governor, Haruhiko Kuroda, announced it will increase its purchase of government bonds from 50 trillion yen a year to 80 trillion. This was announced in tandem with the Government Investment Pension Fund announcing they’ll double their allocation to domestic stocks. The BoJ in essence is crowding savers out of an already conservative investment environment that is Japan. And although the BoJ and GPIF are putting through initiatives that will perhaps help Prime Minister Abe generate that desired 2 per cent level of inflation, uncertainty remains whether it can be successful.

The lingering question is what will be the impact on Japanese savers who do not see the same availability of government debt to purchase and hold. Will they seek out riskier assets, like equities, as was witnessed in the US through QE? Or, is this another factor supporting a strong dollar trade that sees the Yen sold for the alternative of being positioned in US assets, and the benefit of the deepest most liquid capital and treasury markets in the world?

At a conference this week hosted by the Bank of France, former PIMCO CEO Mohammed El-Erian made some very revealing comments. He said, “this is a world which places too much of a burden on central banks. This is a journey, not a destination. If the journey lasts too long, central banks go from being part of the solution to perhaps being part of the problem.” For the moment, only time will tell how this all plays out.

However, if El-Erian’s assertions prove to be correct, than those buying gold at these levels may be one step ahead of the pack if in fact Central Banks continue on their current path. And at this point there is absolutely no reason to think that they won’t.