Not a Good Year for Gold - So Far!

It has been a rough year thus far for those in the gold sector. For the first time in years, gold is down on the year going into the end of May. The last time that happened was 2005. To May 31 that year, gold was down 5% but wound up 18.4% for the year. Since 2001, gold has an unblemished record of twelve consecutive up years. Given that gold is down in 2013, 17.7% to May 28, 2013 it has dug a rather deep hole. For gold to break even on the year it must rebound 21% from current levels over the remainder of the year.

The bulk of gold’s decline came in two weeks in April from the 8th to the 19th when gold broke two-year support near $1,525 and promptly fell $200 losing about 11.5% in the process. The gold stocks were hit even harder with many now trading near multi-year lows. With the TSX Composite up 3.8% thus far this year and the US market on fire with the S&P 500 up 17.5% year-to-date the decline in gold has been a shock to those in the gold market and galling to those who believe they missed the boat in the broader market.

The catalyst for gold to fall $200 in April was the offering on the early morning of April 12, 2013 of 400 tonnes (some said 600 tonnes) of paper gold in the COMEX futures through Merrill Lynch’s futures desk.  The market swiftly broke support at $1,525 triggering stop losses and bringing in more sellers. To date the seller of such a large amount of paper gold remains unknown. 

Helping the decline in gold has been sales from the SPDR Gold Trust (GLD-NYSE) that saw a gold withdrawal of some 179 tonnes in Q1 2013. The withdrawal from the GLD has been, however, more than offset by a surge in demand for jewellery, coins and bars particularly in Asia. Physical volumes have surged through Singapore and Shanghai. Central bank buying particularly Russia, Kazakhstan, Greece, Turkey and China has also surged. Premiums (and discounts) have widened for both the purchase and sale of coins and bars.

One of the reasons given for gold’s collapse has been jawboning from the Federal Reserve that they might taper off their bond purchases for QE3. Fed Chairman Bernanke has not helped the matter by on one hand confirming that QE3 would continue but on the other hand hinting that the bond purchases could taper off at future Fed meetings. While these contradictory statements have hurt gold, they have not hurt the broader stock market that has instead surged to record nominal highs.

Some have said that the recent collapse in gold prices is an attempt to denigrate gold as an alternative currency to the US$. The US$ is the world’s reserve currency and it has been under attack. Given the US’s huge debt (current estimate - $16.8 trillion plus unfunded liabilities estimated at $124 trillion) coupled with ongoing budget deficits, current account deficits and trade deficits losing its status as the world’s reserve currency would be devastating. On the other hand a declining US$ is beneficial to the US in monetizing the debt.

Yet the challenge to US$ hegemony continues. The BRICS (Brazil, Russia, India, China and South Africa) want to create their own version of the IMF and the World Bank. They would not use the US$ as is currently the case. China has been in the process of creating a Yuan currency zone and signing deals with other countries where trade would take place in Yuan rather than US$. Japan embarked on an aggressive QE program to help stimulate the moribund Japanese economy. The Yen as a result has fallen almost 16% thus far in 2013. Some accused Japan of being currency manipulators deliberately devaluing their currency even as the G7 refused to chastise Japan for its falling currency.

Japan’s attempts to revive their economy are having some perverse effects. First, it sparked a huge surge in the Tokyo Nikkei Dow. Second it caused Japanese Government bonds (JGB’s) to fall in price (rise in yield) as fund managers realizing that the Yen would fall sold their JGB’s and converted the proceeds into other currencies for re-investment in higher yielding securities elsewhere. Japan with a debt to GDP ratio well in excess of 200% can ill-afford to have interest rates rise. That is exactly what is happening. Rising interest rates add to the Japanese budget deficits that are already very high and interest payments could crowd out other expenditures including fiscal stimulus.  The stock market may have realized all of this and last week panicked losing 7%. The Tokyo Nikkei Dow lost another 5% on May 29, 2013.

Gold (along with silver) as money has a long history. Even when the world converted to paper money, the gold standard remained as currencies were pegged to gold. While gold coins as specie stopped circulating a number of years ago (Canada stopped almost a 100 years ago and the US stopped in 1933) silver coins or at least coins with a high content of silver were in circulation well into the 1960’s. The gold standard ended in August 1971. Since then fiat currencies have ruled. Money is whatever the government deems it to be. Money today is blips on a computer screen, paper (or plastic) and steel coins with little or no intrinsic value.

Fiat money has exploded upward. US Money supply as measured by M2 (notes & coins, Federal Reserve Bank credit, travelers checks, bank demand deposits, savings & time deposits (< $100,000), money market accounts) has multiplied over 10 times since 1980. The US monetary base (notes & coins, Federal Reserve Bank credit) has almost quadrupled since the start of the financial collapse of 2008 largely due to an explosion in Federal Reserve Bank credit. The Fed stopped collecting data for M3 (M2 plus large time deposits and institutional funds, repurchase agreements) in 2005. M3 is estimated to have grown 1.5 times since the Fed stopped reporting data to a level today of $15.1 trillion.

Source: www.stlouisfed.org 

But what has really exploded since the world came off the gold standard is debt. US total debt (governments, consumers, corporations and business) today is estimated to be $56.3 trillion a sharp increase from the estimated $1.8 trillion that was outstanding in August 1971. Central banks and private banks did not like the gold standard and lobbied hard to kill it. Why? For the simple reason that gold is limited in supply and it is not easy to find. It prevented central banks from managing and growing the money supply the way they wanted to and it held back the growth ambitions of the private banking sector.

Since the financial crisis of 2008, the Fed has brought in QE1, QE2, Operation Twist and now QE3. They have also lowered interest rates to virtually zero. As a result, real interest rates are negative. QE was instituted to keep the US government afloat and to prevent the US banking system from collapsing. What QE is not is stimulus for the economy. If it were, then the banks would be lending, money velocity would be rising not falling and the money multiplier would be rising not falling. The banks are not lending to any extent. The financial crisis of 2008 forced the banks to tighten credit rules and fewer (consumers, business etc.) are credit worthy today then was the case prior to the 2008 financial crisis. 

The Fed may be in a liquidity trap. A liquidity trap occurs when interest rates are at or near zero and despite growth in the monetary base it is not translating into growth in the economy and a rise in price levels (inflation). The Fed instead may be facing deflation. The falling money velocity and money multiplier are signs that the money (QE) is not getting into the broader economy. The banking system is essentially bankrupt and it needs the money to cover its toxic loans and paper and underwater derivative positions.

All of the western nations including the Euro zone and Japan are employing QE and maintaining near zero interest rates for largely the same reasons – an attempt to keep the government debt afloat and prevent a collapse of the banking system. Many of the major banks in the Euro zone, Japan and the US are woefully undercapitalized. A “too big to fail” bank collapse today is more likely to have depositors pay as opposed to the taxpayer as was the case in the past.

Government debt to GDP is over 100% in the US; over 200% in Japan and approaching 100% in the Euro zone, (although a number of individual Euro zone countries have a debt to GDP ratio in excess of 100). Given the size of their debt, the governments cannot afford to have interest rates go up as it would balloon their budget deficits and most likely end whatever feeble recovery is underway.

  Source: www.stlouisfed.org

QE has exploded the Fed’s balance sheet. In August 2007 the Fed’s balance sheet totaled $869 billion. Today it is over $3.4 trillion. Included on the balance sheet is roughly $1.2 trillion of mortgage-backed securities (MBS) of varying quality. It would be very difficult for the Fed to sell the portfolio, as the buyers would probably have to be the same banks that the Fed is currently buying from through QE3. The Fed ending QE could cause the stock market to collapse and interest rates to spike. Given the economy is barely registering growth it would probably spark a recession.

A recession is what the Euro zone is in with most every country in the zone in either a depression (Spain, Portugal, Greece etc.) or barely growing (Germany). Japan is showing some signs of growth but that was before the recent stock market reversal and the spike in interest rates. Many point to the reviving US housing market as a sign that the economy is coming out of its “funk”. A closer look at the so-called housing recovery reveals that there is very low housing supply and much of the volume of sales is being driven by investor money pouring into single-family homes and converting them to rentals.

With investor money pouring into single family homes it is pushing up prices but the reality is that over 10 million US homes (some estimates are that it is as high as 13 million) are underwater with their mortgage larger than the value of their house. Despite the so-called improvement in the US housing market the delinquency rate remains high as the chart below attests (as reported by Freddie Mac and Fannie Mae – note: today the rate is down to around 3% but that is still well above levels reported prior to the sub-prime crisis of 2007).

Source: www.calculatedriskblog.com

  
Against all of this backdrop interest rates are rising. No, it is not the official Fed rate. The Fed rate is not likely to rise. That should keep short term interest rates relatively low. US Treasury rates are under 0.50% out to 3 years. But after that the yield curve is steepening. Five year Treasuries are now over 1% and ten year Treasuries are over 2%.

The chart of the TNX 10 year Treasury Note Yield Index (TNX-CBOE) shows that yields bottomed back in July 2012 at 13.94 (1.394%). Since then there has been a series of rising highs and rising lows. The TNX has recently broke out once again to new highs at 21.12 (2.112%). There may also be a head and shoulders bottom forming (or has formed). Rising interest rate yields for US Treasuries puts upward pressure on a host of other interest rates including long dated corporate debt and mortgage rates.

Source: www.stockcharts.com

Gold prices have been in a slump. It has pommelled investors in the sector and left many a gold supporter squirming. The reality is despite the slump nothing has changed except that someone was successful in pushing gold prices sharply lower. As was noted at the start the perpetrators of the sale of 400 tonnes of paper gold on April 12 have never been identified. Theories have been put forward from Fed manipulation to large players wanting to push the price lower in order purchase physical gold at a sharply lower price. Certainly if there was a surprise following the mini-crash, it was the unprecedented wave of physical buying that took place.

Bearish sentiment for gold has rarely been higher (or in this case lower). Bearish sentiment is near levels seen at the 2008 crash lows. However, it is higher than sentiment at the 2001 lows or the 1982 lows. Given that bearish sentiment is above the lows of 2008 it is possible that sentiment could get worse before it gets better.

Source: www.sharelynx.com 

However, the tide may be turning. Last week’s upside bullish engulfing candle was encouraging. So was the sharp outside day reversal seen on May 20, 2013. It was a classic reversal day as it came “out of the blue” after the market was down earlier in the day. The collapse in April took gold down below the four year MA. That was only the second time since the bull market in gold got underway in 2001. The previous time was during the 2008 financial crash and gold did not at that time actually trade below the four year MA although it came close to the average.

Gold also touched down to a bear trendline off the lows of September and December 2011. Gold was also close to a bull trendline coming up from the 2005 lows and connected to the 2008 lows. Almost universally many prognosticators are expecting gold to fall to $1,100 to $1,200. With that many on the bear side (negative sentiment) the sell side for gold was becoming crowded. It is out of these conditions that sometimes upside reversals occur. Short open interest has gone up over the past few weeks. If the market were to suddenly rally these new shorts could be fuel to a further rally if a short squeeze were to get underway.

It has not been a good year for gold – so far. However, there are still seven months left in the year. The reasons and conditions that helped push gold to $1,900 back in 2011 have not gone away. If anything, the conditions have intensified even as the broader stock market throws off appearances that all is well. 

copyright 2013 All Rights Reserved David Chapman

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