Investors have not been this optimistic about the global economy since the financial crises. And as of late, there have been a consistent number of positive economic reports that have continued to contribute to this rally in the equity markets. With the yield on US 10 year bonds back up over 2 percent today, it is evident that a risk on play is continuing to develop in the markets. And as safe haven sovereign debt sells off, metals have benefited from this trade.

I think it’s in my blood to be a skeptic, and that side of me will overcome the joyousness shortly, but it is important to start with the positives in this market right now. Despite the rejigging of corporate balance sheets and the profits that prevailed from businesses vastly cutting costs, the US private sector looks to be optimistic about the economy, and for that reason they are hiring. The job numbers released this morning (which are looked upon with caution because of their volatility) are for the first time since the financial crises one level above mediocrity. Given the US labor market requires growth of anywhere between 90 to 120 thousand jobs a month to keep up with population growth, seeing payrolls add over 220 thousand positions is very positive and hopeful for economic growth.

It is also the hope and optimism of investors that has continued to fuel this rally in the stock markets. The Dow Jones Industrial Average took out its previous high set in October of 2007, and came back from the low of below 6,500 in March of 2009. There were many pundits who did not seem to care because of the Dow being an outdated and undiversified index, and in a sense they are all correct, but the real reason it is attracting this much attention is because the valid S&P 500 will shortly tell a similar story.

There is no question these markets have come back from some very dark days, and right now it’s hard to argue that equities are not the place to be, but there is more than the optimism of investors that is carrying this market. Since its bottom in March of 2009, equities have been lifted by the operations of the US Federal Reserve as they ensured liquidity in the US financial markets. It was the fact the Fed could act as a back stop for creditors, and guaranteed to borrowers that interest rates would not skyrocket that there is this level of optimism in the market. Referring to the graph, the highlighted time periods represents purchases of treasury bonds and Asset Backed Securities by the US Federal Reserve and the actions of their efforts is quite clearly evident.

With this much optimism in the markets it does not take too much time for the typical economists or analysts of other views to raise warning flags. Nouriel Roubini, the economist known for calling the housing market collapse believes the crash from this bubble in this bond market will be greater than the previous crash of financial markets in 2008-09. There is no question as to whether or not there is a bubble in the bond market, especially when you have the world’s most powerful central bank suppressing interest rates and holding up prices. The question is instead, what’s there exit plan?

US stock markets have come back from the lows of 2009 and that is great. And broadly speaking, US stocks do represent the opportunity in this market at the moment. But instead of trying to make my case myself, I’ll quote former Citi CEO Chuck Prince.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” That was in July of 2007. Refer to the graph above to see what happened next.

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The release of January’s FOMC minutes had a fairly substantial impact on precious metals this week as on Wednesday alone we witnessed more than a 2 percent sell off in the price of gold. Some analysts attributed this sell off to investors closing out gold positions as a number of them had been financed with borrowed money. The deleveraging witnessed in gold futures positions could very much be attributed to the downward movement in the price, but there is a bigger picture here in terms of what we are seeing in the markets and that is the expectations of higher interest rates.

The dissent at US Fed revealed by January’s minutes highlights the uncertainty from committee members regarding the costs and benefits of their bond purchasing program known as Quantitative Easing. There is beginning to be a revelation from committee members that by supressing long term interest rates high risk borrowers are able to finance credit at what might be discounted prices. This a direct off-shoot of the actions of the Fed extending the duration of their balance sheet by holding longer term bonds opposed to paper with a shorter period to maturity. As increasing number of committee members now fear, they very well could be setting up another asset bubble in junk bonds and high risk mortgages as these borrowers have been given the potential to overburden themselves with debt. In fact, when borrowers are able to finance debt at a lower than “usual” interest rates, it means that the price of that debt is perhaps overvalued, hence the bubble.

On Wednesday, all markets took this as the Fed could be ending QE a lot sooner than we expected. Not only did commodities take a hit, but as well equities sold off as risk appetite left the market place, which is accompanied by resurgence in the greenback. If it is the US central banks approach to begin scaling back their asset purchases, the Fed would likely take a loss on the long term bonds it holds as they attempt to trade them back into the market. It’s no secret that this is the Fed’s endgame as they look to reduce the same balance sheet representing the US currency that has more than tripled since the onset of the Sub-Prime Crises. However, the doubt amongst investors is still how the Fed plans on doing this, and perhaps at what price will the market absorb this barrage of US government debt?

This alone provides rational for the potential of long term interest rates starting to rise. Simply for the fact that not only will investors require a much higher interest rate as the economy now carries a credible risk of inflation over the longer term, yet also such a sudden bond supply increase discounts prices and in turn create upward pressure on interest rates. Therefore, savings that were sitting in gold could be sold off as these funds could flow back into the market and potentially earn a more attractive yield over time. This has to do with the potential of real interest rates rising and money leaving real assets.

The question we have to ask though surrounds what happens to the hopes of this US economic recovery when the above situation unfolds. Furthermore, when the US Federal Reserve begins to tighten monetary conditions and in turn reduce their bond holdings, with very high probability the market reaction in terms of interest rates will not be quite as theoretical as I have played out. It could be accompanied by some turbulence.

To digress, I find it humorous whenever someone tells me with great certainty that gold will hit 2500 US/oz. or some other ambiguous figure in a certain period of time. I loosely believe in the efficiency of markets, and as always the price of gold is reflected in its current price. If it should be 2500 US/oz., then it would be that price today. Nonetheless, gold closing the week at 1581.19 US/oz., down 2.3 percent hasn’t spooked me from holding it as it still has value as a hedge against that economic uncertainty that will prevail.

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Record petroleum exports out of the US in December contributed to the geopolitical superpower narrowing their trade deficit by more than 10 billion USD. This allowed them to record their trade deficit at what is now a three year low. As the US trimmed back their imports in the month, the decrease in their deficit was also attributed to exports surging by 2.13 percent. It’s time for Canada to determine whether it wants to continue to play a prominent role in the State’s energy production. Right now, however, it does not look like we are very proactive in expanding our energy exports anywhere in the world.

Canada’s December trade numbers were abysmal. It’s no surprise that in a month when US oil imports are at the lowest level since 1997 that our exports amount to a drag on our gross domestic product. Data from the last decade shows the opportunity Canada has had in exporting our oil to the US. In 2002, Canadian crude accounted for less than 16 percent of the all US crude imports. Estimates are that that number is as high as 28 percent in 2012, and that was during a period when the US faced a decline in oil imports. The ease and opportunity for the US to import oil from a sound Western government such as Canada has crowded out their imports from less politically stable countries.

For a western democracy, however, direct concerns of stability are more centered on our economy vis-à-vis the housing and financial markets. It is no surprise that the Canadian housing market has gathered international intention, especially following the British governments attempt to interrogate Governor-elect Mark Carney for his record at the Bank of Canada. But what we are witnessing in Canada is no different to what other nations such as the US, UK, and Spain have witnessed in the past. Each of the aforementioned countries followed the pattern of household debt levels increasing in tandem with house prices, and as a result eventually saw a price correction. As is apparent with the Canadian market, house prices are yet to correct.

It’s my opinion though, that instead of waiting for prices to correct, there lays an alternative option to bring our household imbalances into check; exploit our natural resources, which will present opportunities inclusive of job creation and thus economic prosperity. Without missing an opportunity to take a shot at President Obama, the Keystone XL pipeline should have been approved in his first term in office. If he was less worried about the Electoral College votes from the state of Nebraska and more concerned over US job creation, greater volumes of Tar Sands crude would already be heading to the Gulf of Mexico. For that matter, when the opportunity arises to sell crude or natural gas to Asia, we’d rather flip flop around the actual issues and glorify so called environmentalists.

Beyond Canada’s housing market’s relation to that of the US, UK, and Spain, we’re not that different from other small western nations that have witnessed both real estate prices increase and been hindered by an appreciating exchange rate. Countries like Switzerland, Sweden, New Zealand, and Singapore have all fought a stronger currency while attempting to grow their economies, and in turn their housing markets attracted capital. The real assets of these nations are what investors perceive to have value when there is global uncertainty in equity markets. That is why when people suggest we are amidst a recovery, that people start to question whether home prices are overvalued.

In very simple terms, Canadians on average are overleveraged. We are holding too much debt. Why then, when there are present opportunities to relieve household imbalances are we balking at the opportunity to prosper as a nation?

 

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News surfaced this week that the Bundesbank, Germany’s central bank, was recalling some 674 tonnes of gold that they hold outside of the country. This came as quite a surprise as this particular gold has been stored with the New York Federal Reserve and Bank de France for decades. But many were asking the question, why does it matter where Germany stores their gold?

Following World War II and the beginning of the Cold War, the majority of Germany’s gold was moved to the safekeeping of western central banks as a threat of Soviet invasion loomed; however, not until the end of the war did Germany start bringing their gold home. Germany is the world’s second largest holder of gold, and they held as little as three percent of their entire holdings domestically during the wars. Currently, that number is around 31%, and their plan is to hold about 50% of their gold in Frankfurt by 2020 by repatriating these 674 tonnes from New York and Paris.

Various commentators have tried to provide rationale for why Germany would have the incentive to do this with reasons ranging from the US Fed and central banks lack of proper auditing practices to the gold actually not being there. Giving conspiracy theories only so much credibility, I think Germany’s motivation is deeper and stems from the geopolitical risk of a breakup of the European Union.

Economic growth across the Eurozone is stagnant at best as they look to start off 2013 in a double dip recession. The Euro Zone sees almost a quarter (24.7%) of their labor force under the age of 25 unemployed and seeking work. And rates are higher in peripheral Eurozone countries like Greece, Spain, and Italy, who saw youth unemployment increase to 57.6%, 56.5%, and 37.1% respectively. The social unrest in these countries stems from the inability to find and/or keep work, and this ongoing problem that bares no present solution is what threatens the single currency zones present stability.

Through these times of economic uncertainty it is gold’s role in international finance that safeguards a number of these European nations from extreme currency instability. It’s interesting to note that while Germany looks to repatriate a large portion of their gold holdings, that these countries are still largely dependent on the precious metal. As the German’s are the second largest holder of physical gold, not far behind are Italy, France, and the rest of the EU to make up over 10,000 tonnes and almost a third of the World’s Central Banks’ Foreign Exchange Reserves. The very asset that backs their currency, unlike a lot of Asia, which post Bretton Woods opted to hold US dollars, is predominantly made up of gold. In essence, that is why Europe’s central banks are bound by an agreement referred to as CBGA3 which limits them flooding the market with large quantities of physical gold.

This preamble circles back to the importance of Germany bringing home their gold to store domestically, and I believe their reason for doing so is not unlike the typical retail investor who holds gold. Gold is the hedge or the insurance against debasement of currencies and geopolitical risk. I hope for the sake of the Nobel Price-winning Canadian Economist, Robert Mundell, that the Eurozone does not dissipate, but this move by Germany may be hedging against just that.

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The US Federal Reserve revealed from their December meeting that several of their voting members would opt to end their extensive bond purchasing program, known as Quantitative Easing, by the end of 2013. It was back in November of 2008 when the US Fed initiated this monetary stimulus effort, and just for reference the price of gold closed that month at 811.30 USD/oz. It’s no secret the price of gold has moved up significantly in response to the US central bank’s issuance of cheap credit at the cost of their dollar, but the question then becomes what happens to the price of gold when the Fed takes the punch bowl away?

Well, that is a scenario that I do not think we need to worry about just yet.

There is no set in stone timeline for when this stimulus program will end, but it is up to the Federal Reserve’s Policy setting committee. The structure of the Fed’s policy setting committee (known as the Federal Open Market Committee, or FOMC) has it so that the majority rules. Of the twelve voting members, there are seven Federal Reserve board governors, including chairman Bernanke, which traditionally vote in unison. The remaining five positions rotate between the 12 Federal Reserve District Bank presidents, and that is there there can be dissent from the consensus. This structure, however, ensures the governors have their majority in all decision making.

The renowned Bond Fund investor Bill Gross of PIMCO stated on CNBC following the release of the FOMC December minutes that it’s too early to put an end date on this monetary policy experiment. The incoming voting members of the FOMC are more dovish and will support a more accommodative policy going into 2013. For this reason alone, it’s too soon to anticipate these bond purchases will be wound down.

In fact, James Bullard, the St. Louis Fed’s district president promptly told media following the release of the December minutes that it will take a significant improvement in the economy to end the program instead of setting some tentative date. This was his effort to make clear that the Fed’s expectation is for the economy to improve by the end of this year, such that they will no longer need to supply such a supportive policy; moreover, cutting back bond purchases is very conditional on an improvement in output and labour markets.

In an introductory course to macroeconomics we learn how central banks may utilize the media to affect consumer and business confidence. If business’s all truly believe that the economy will improve by the end of 2013 maybe that will prompt them to go out and hire more employee’s and increase capital expenditure and investment. But then, how much of the Fed’s forecast for the improvement in the economy is based on the fact that business and consumers will react in this way?

My view is that the US economy will continue to advance at a mediocre pace in 2013. Friday’s job’s report helped illustrate that the labour market is only moving in accordance as job creation remains quite weak and only slightly outpaces the growth of their labour force.

The US Federal Reserve will have no choice but to continue their experiment known as Quantitative Easing due to how reliant this fragile American economy truly is. With a stalemate in Washington that only looks to get worse, the next bump in the road will be negotiations on the budget ceiling and the imposition of spending cuts that the federal government keeps delaying. This will lead to very cautious levels of investment and consumption akin to 2012. With a market potentially expecting an end to this program by 2013 year-end, any extension will be very bullish for gold.