Gold Remains Essential!

I continue to believe that the above chart may still be the most important chart to follow when it comes to determining the future price of gold. Nor am I alone in this belief.  The chart is the US monetary base. Thus far, in 2013 the US monetary base has grown by 23.3%. Gold has fallen 22% in the same period. There has been a close relationship with gold and the US monetary base. One of them appears to be “out of sync”. As long as the Fed continues to pump $85 billion a month into the banking system, the monetary base is unlikely to contract.

So what is the monetary base? The monetary base or base money is the sum of all circulating currency, plus commercial banks’ reserves with the central bank. The monetary base differs from money supply (M1) in that bank reserves are not a part of M1. M1, however, does include traveler checks plus demand deposits and other checkable accounts.

The US monetary base exploded with the financial crisis of 2008. That year the monetary base roughly doubled because of the TARP programs and others that resulted in billions of dollars being pumped into the banking system in order to prevent a financial collapse. Gold responded with strong gains in 2009 and 2010. Since the onset of the millennium, the US monetary base has grown by 410% whereas, after the recent drop, gold is up 346%.

The US reports and supposedly holds 8,133.5 metric tonnes of gold (261.5 million troy ounces) as part of its foreign exchange reserves. I say supposedly because there have been over the years numerous questions raised about its existence.  The US has not allowed an audit of its gold reserves since the early 1950s and all requests to confirm the holdings have been rebuffed.

Based on official holdings, a gold price of $12,410 an ounce would be required to allow the gold reserves to fully back the monetary base at current prices.  At the beginning of the millennium, a gold price of $2,434 would have been required. In September 2008, as the financial crisis was unfolding and before the Federal Reserve pumped billions into the financial system, a gold price of $3,632 an ounce would have been required to back the monetary base.

The monetary base has more than tripled since the financial crisis of 2008 got underway but gold prices have only gone up 1.5 times. Even at their highs in 2011 gold prices had only gone up 2.2 times from the October 2008 lows. Gold prices are now back where they were when QE2 was getting underway in 2010.

If the US monetary base has gone up sharply so has the Federal Reserve’s balance sheet. According to the most recent reports, (FRB H.4.1 released June 20, 2013) the Fed’s balance sheet now sits at $3.5 trillion. The Fed’s balance sheet has grown from $2.9 trillion since January 2013 an increase of almost 21% or 41% annualized. Some $1.2 trillion is made up of mortgage-backed securities (MBS) of questionable value. Of the $85 billion, a month the Fed is purchasing under QE3 $40 billion are MBS and the remaining $45 billion is US Treasury securities.

Despite the Fed’s buying, interest rates are rising at the long end of the yield curve (10 year US Treasury yields have gone from 1.43% to 2.60% since July 2012). Under these conditions, it would be extremely difficult for the Fed to sell its portfolio back to the market. Given continuance of QE3, the Fed’s balance sheet can only grow. Ultimately, the growth in the monetary base and the Fed’s balance sheet is inflationary. Many point to the inflation rate and say that there is no inflation. There is no classic price inflation but there has been asset inflation in stocks and possible once again in the housing market. Could rising interest rates in the long end of the curve be a trigger to end the asset inflation?

Gold’s most recent sell-off was triggered last week by Fed Chairman Bernanke’s musings about cutting back on QE. He even set a timetable that it could begin later this year and come to an end sometime in 2014. The media immediately dubbed it the “taper”. Not only did gold and other commodities sell off but the stock market sold off, interest rates particularly at the longer end of the yield curve rose, and the US$ soared against other currencies. China heaped fuel on the fire with the Fed’s counterpart, the People’s Bank of China (PBOC), engineering a cash crunch as a warning to its over-extended banks. The Chinese stock market reacted by selling off sharply as well. Since then China and some other central banks have been forced to come forward to try to calm the markets.

The sell-off in global stock markets got started about a month ago when Japan destabilized its soaring stock market by not providing even more stimulus when the market expected it. Even before US interest rates began to rise, a host of European junk bonds in Spain, Italy, Greece and Portugal were seeing rising bond yields after the bloom came off their markets. If Bernanke was trying to cool the overheated US stock market, he succeeded. But he cannot be too pleased about rising interest rates as they could quickly stifle the US mortgage market and in turn cool the nascent US housing recovery. The Fed does not intend to raise the official Fed rate, so short rates should remain at or close to zero.

Seemingly missed by listeners was Bernanke’s remark that any tapering of the current round of QE is dependent on economic data showing improvement. He also made it clear that it would not be cut back based on economic data but on the Fed’s interpretation of the data. Quite simply, if the data does not improve according to the Fed’s definition there would be no “taper”. The market, however, wants to hear what it wants to hear, and the key word for the market was that the Fed could begin to “taper” off its QE program later this year and end it next year. The selling was by large funds, especially hedge funds and others from the shadow banking system, rushing to the exits with their trading positions. It is not as if the volumes have been huge but volume did pick up in the stock market.

The market seems to have lost sight of the fact that QE is what has been holding the markets up. With stock markets and real estate rising, the expectation was that the overall economy would soon improve. But rising stock markets and real estate have been dependent on QE. Take away the QE and the result is as expected. The stock market falls and interest rates rise. The economy remains too burdened by huge amounts of debt both government, corporate and individual. US government deficits remain at or close to $1 trillion annually. Japan and Europe are in the same position with unsustainable debt and budget deficits. With government debt-to-GDP ratios at or near 100 in Europe and the US and over 200 in Japan, it is almost impossible to have the economy gain any traction unless their economies ramp up to even higher levels of debt. Since the western economies have hit the debt wall the governments of Europe, the US and Japan can only hope that QE has the same result as huge amounts of new debt. Economic recovery has been nascent but asset prices have soared, giving the appearance that all might be well.

It isn’t. The Eurozone is a mixed bag of countries in outright depressions (Spain, Portugal, Greece, Ireland) or in recession (Britain, France) or limping along (Germany). The US and Japan limp along. Take away QE and limping along would most likely become recession (or worse) once again.

So what will happen next? The most likely outcome is that currency wars intensify as each country seeks a competitive advantage against the others. That ultimately should revive the moribund gold market.

That gold has suffered as it has is a mystery. Even before the recent Fed musings, gold prices were falling because of thoughts that the Fed might begin to ease up on QE. Why gold fell even as the stock market rose was a disconnect. In mid-April, some 400 tonnes of paper gold (futures) was offered into the market in a very short period. The result was the huge $200 meltdown in gold prices over April 12 and April 15.

There are few players in the gold market that could offer such huge size at once.  That led to speculation that it might be the Fed behind the sell-off. Certainly there was motive, as gold was being seen as an alternative currency to the US$. 

The gold collapse in April caught the gold community off-guard. While it was acknowledged that a breakdown under $1,525 could lead to a spike to the downside, many believed it would not occur, as the reasons for holding gold remained as strong as ever. While traders may have benefitted from the collapse, investors have been going through a nerve-racking period. That is understandable, but to repeat, the reasons for holding gold remain as strong as ever.

Bearish sentiment, especially for the gold stocks, remains exceptionally high. Given the drop in the price, marginal operations are being threatened and numerous junior exploration stocks have either ceased or scaled back operations. Meanwhile demand for gold has remained high and there has been strong evidence of continued central bank buying, particularly from Asian countries. Demand has remained high in India despite attempts by the Indian government to curb imports. Insider trading in the gold stocks is running 10 to 1 in favour of buying.

Despite one of the most oversold conditions and most bearish sentiment seen in years for gold, there are numerous pundits predicting even lower prices. The main bearish reports come from the bullion banks. Many believe that the bullion banks were caught short gold and have been using this opportunity to square their positions through the purchase of physical gold replacing paper gold. As the June futures expiration approached (last trading day is June 26) there was a large drop seen in the short open interest. Could it be that the large short put on in mid-April was covered?

There has also been a continual decline in the gold stocks held by the COMEX. The open interest/gold stocks ratio (owners per ounce of gold) at the COMEX as a result has been rising although it is not at levels that could be considered alarming. On the other side, the commercials Commitment of Traders (COT) has reached its highest levels in over 8 years just before another strong rally got underway for gold.

Volume and a technical tool called on balance volume (OBV) may be a clue to where the markets might go next. On balance volume is used to confirm the current price direction or it can warn of an impending reversal, given divergences with the price action. OBV is a simple calculation. The total volume for the day is assigned a plus or minus value depending on whether prices close higher or lower on the day. For OBV it is direction that matters, not actual value.

The chart of Barrick Gold (ABX-TSX) is a case in point. Barrick Gold has seen a 68% decline from its December 2010 top. It has had problems with the closing of its Pascua Lama mine in Chile by the Chilean government. It recently announced the layoff of roughly 30% of its executive staff, primarily at its head office in Toronto. Quite a comedown for the world’s largest gold mining company.

There was a huge spike in volume when Barrick collapsed in mid-April 2013. OBV confirmed the price decline. The RSI registered deeply oversold at the lows on April 16. The deeply oversold reading remained in place for a few days even as Barrick started a feeble rise. Barrick fell to new lows this past week with the OBV once again registering new lows and confirming the price decline. If there was a difference this time, however, overall volume fell sharply as compared to the mid-April drop. The RSI is also diverging with the price lows of mid-April. A breakout over $22 would confirm at least a test of the 100-day moving average, currently near $25.

Gold has had an odd performance since the major correction got underway following the highs of September 2011. Volume declined during periods of corrections. The OBV confirmed the declines during 2011 and 2012. While volume rose during the mid-April 2013 sharp sell-off volume levels were generally lower than they were during the sideways movement of 2012. Volume rose during the brief rebound following the mid-April 2013 collapse, then fell again as the market fell sharply this past week following the Bernanke speech. OBV rebounded but it has not yet confirmed the new price lows for gold. The weekly RSI is diverging positively thus far with the price lows of mid-April 2013.

 

None of that is to suggest that the final low is in, even as gold appears to have fallen to levels of major support on the downtrend line that joins the lows of September and December 2011. Gold may have completed a five-wave down structure from the highs of October 2012. As well, gold appears to have traced out an ABC corrective pattern from the highs of September 2011.

Only a break and return above at least $1,420 and preferably above $1,500 would suggest that the final low is in. Seasonals do turn up for gold in July. The deeply oversold conditions and extreme bearish sentiment suggest that at least a corrective up move could soon get underway. There remains some risk of slightly lower prices. The bottom of the channel is currently around $1,245 but a spike under that level would not be unusual in this environment. If the channel trend line is correct, the worst should be over.

The broader stock market has been giving a different picture. The Dow Jones Industrials (DJI) has turned down, breaking below the 13-week MA for the first time since a pullback in October 2012. Potential objectives could be down to 14,000 or 13,800. Volume has ticked higher on this pullback. If one looks back, volume actually rose on the pullbacks in 2010 and 2011. This is not what one would expect in a true bull market. The pullbacks in 2012 were not that significant and volume did not change significantly. The rise in OBV began to slow down and even flatten to some extent, despite the market price rising sharply from March until May 2013.

 

The current pullback in the broader market is just the first one. If history holds, then following a pullback the market could rally back to the former highs and even see new highs. This was a characteristic in 2000 and in 2007 prior to the 2000-2002 and the 2008 collapses. Volume to the upside has overall been weak since the up move got under way in March 2009. As noted, corrections in 2010 and 2011 saw a surge in volume rather than a decline in volume as one would expect in a bull market. This suggests that the up move since March 2009 has been corrective and not the start of a new long-term bull market as many would like to believe.

Fed Chairman Bernanke has been jawboning. Talk about tapering is only talk. The reality is that he cannot, unless the economy is able to embark on another debt-fueled upswing as it did during the 1990s and from 2002 to 2007. The western economies of the Eurozone and the US plus Japan cannot support another debt-fueled binge. QE is the replacement for more debt. Bernanke said that ending QE was contingent on the economy recovering in line with its expectations. Debt-laden economies cannot move forward unless the current debt is brought under control or it contracts. Bernanke even hinted that if instead the economy contracted or slowed down again they might need to boost QE even further.

Bernanke’s jawboning caused the stock market to fall and interest rates to rise. Imagine what might happen if they actually did taper or end QE. The global banking system remains essentially a mess laden with bad debt particularly sovereign debt, mortgages and especially in the US municipal debt where numerous municipalities are bankrupt or close to it.  In 2008, the banking system was on the verge of collapse and the central banks and governments were forced to take extreme measures to prevent the collapse.

The problems that caused the collapse, however, remain. Governments are trying to change the tune by ending taxpayer bailouts and instead switch the risk to bank depositors and bondholders through bail-ins. Naturally the banks object. The banks are also resisting any attempts to re-segregate retail banking and investment banking. With retail and investment banking all part of the bank the banks knew they could leverage up their balance sheets in their investment banking arms, and if it “blew up” the taxpayer would come to the rescue. The taxpayer is now tapped out. Hence the move to bail-ins and the desire to bring back the equivalent of Glass-Steagall once again (separation of retail and investment banking).

Until all of these problems are resolved, holding gold as insurance is just prudent. Gold has been going through a long correction. But the reasons to hold it have never gone away.

On the other side, markets have been rising on a binge of QE. Just the suggestion that the equivalent of the “crack cocaine” for markets could end was enough to send them into a tailspin. Meanwhile the banking system has not resolved the problems stemming from the 2008 financial collapse. It is there that the seeds of another collapse are being sown. That, and an intensification in the currency wars that have been ongoing for the past few years.

The world lacks a sound money system. Under the current fiat system of money central banks can intervene in markets however they like and can expand their money supply at will. The banking system has reached its natural zenith with its ability to leverage itself far beyond what is prudent using a vast array of instruments that the average person does not understand let alone even know their bank is using them. Depositors’ funds are now at risk. The taxpayer is tapped out. It is the next logical step to bringing the biggest debt binge in history to heel. A return to a precious metals based system of sound money would go a long way to re-balancing the banking system.
                                                                                                                

copyright 2013 All Rights Reserved David Chapman

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