Gold sell-off: there is only one question that matters

Last Friday I participated in a (very short) debate on BBC Radio Four’s Today Programme on the future direction of gold. Tom Kendall, global head of precious metals research at Credit Suisse argued that gold was in trouble, I argued that it wasn’t. So yours truly is on record on national radio on the morning of gold’s two worst trading days in 30 years arguing that it was still a good investment.

Is it?

I still think that what I said on radio is correct and even after two days of brutal bloodletting in the gold market and two days of soul-searching for the explanations, I believe that this is the only question that ultimately matters for the direction of gold:

“Has the direction of global monetary policy changed fundamentally, or is it about to change fundamentally? Is the period of ‘quantitative easing’ and super-low interest rates about to come to an end?”

If the answer to these questions is ‘yes’ then gold will continue to be in trouble. If the answer is ‘no’, then it will come back.

Reasons to own gold

The reason why I own gold and why I recommended it as an essential self-defense asset is not the chart pattern of the gold price, the opinion of Goldman Sachs, or the Indian wedding season but the diagnosis that the global fiat money economy has check-mated itself. After 40-years of relentless paper money expansion and in particular after 25 years of Fed-led global bubble finance, the dislocations in the global financial system are so massive that nobody in power dares to turn off the monetary spigot and allow market forces to do their work, that is to price credit and to price risk according to the available pool of real savings and the potential for real income generation rather than according to the wishes of our master monetary central planners.

The reason why for almost half a decade now all the major central banks around the world keep rates at zero and print vast amounts of bank reserves is that the system is massively dislocated and nobody wants the market to have a go at correcting this.

There are two potential outcomes (as I explain in my book): 1) This policy is maintained and even intensified, which will ultimately lead to higher inflation and paper money collapse. 2) This policy is abandoned and the liquidation of imbalances through market forces is allowed to unfold.

Gold is mainly a hedge against scenario 1) but it won’t go to zero in scenario 2) either. So far, I see little indication that central bankers are about to switch from 1) to 2) but we always have to consider the fact that the market is smarter than us and has its ears closer to the ground. What is the evidence?

Cyprus and EMU

Taken on their own, events in Cyprus were not supportive of gold, not because the island nation could potentially sell a smidgeon of gold into the market but because the EU masters decided to go for liquidation and deflation rather than full-scale bailout and reflation. Cyprus’ major bank is being liquidated not rescued and ‘recapitalized’ as in the bad examples of RBS, Northern Rock, Commerzbank, or more indirectly – via shameless re-liquification – in the case of Goldman, Morgan Stanley, Citibank and numerous others. The ECB’s balance sheet has been shrinking over the past 3 months, not expanding. Depositors in EMU (and even EU-) banks are being told that in future they shouldn’t rely on unlimited money-printing or on unlimited transfers from taxpayers in other countries to see the nominal value of their deposits protected. This is a strike for monetary sanity and a negative for gold. It should reduce the risk premium on paper money on the margin.

If this sets an example of where the global monetary bureaucracy is moving than gold is indeed in trouble. However, I don’t see it. As I argued before, it seems more likely to me that Japan is the role model for where other central banks will be heading: aggressive fiat money debasement, a last gasp attempt at throwing the monetary kitchen sink at the economy. Additionally, the EU bureaucracy may not be as principled on the question of hard or soft money when the patient brought in on a stretcher is not a European midget like Cyprus or even Greece but one of the big boys, i.e. Spain, Italy or France, the latter having been the EMU’s big accident waiting to happen for some time. Mr Draghi’s phone will immediately ring off the hook. My sense is that even in Europe the days of ‘quantitative easing’ are not numbered by any stretch of the imagination.

Bernanke, the anti-Volcker

But the central bank that really matters is the Fed. Will we one day look back on the days of April 2013 as the moment an incredibly prescient gold market told us that Bernanke was getting isolated at the Fed, that people had begun to seriously tire of his academic stubbornness about the U.S government having a technology, a printing press, that allows it to print as many dollars as it wishes….blah, blah, blah…., and finally got the knives out and finished this undignifying spectacle of madcap dollar debasement? – Of course, I don’t know but I somehow doubt it.

Monday was the worst day in the gold market since February 1983. Back then gold was in a gigantic bear market, not because of what Goldman thought or said, but because Paul Volcker was Fed chairman and had just applied monetary root canal treatment to the US economy simply by stopping the printing presses, allowing short rates to go up and restoring faith in the paper dollar. Hey, 20 percent on T-bills, how is that for a signal that paper money won’t be printed into oblivion! The important thing was that Volcker (and some of his political masters) had the backbone to inflict this near-term pain to achieve longer-term (although, sadly, not lasting) stability and to live with the consequences of the tightening. Today, the consequences would be much more severe, and there is also much less central banker backbone on display. Over the past two decades, the central banker has instead become the leveraged trader’s best friend. Volcker was made of sterner stuff.

If the gold market knows that easy money is about to end, how come the other markets haven’t got the news yet? Do we really believe that stocks would be trading at or near all-time highs, the bonds of fiscally challenged nations and of small-fry corporations would be trading at record low yields, if the end of easy money was around the corner?

To justify the lofty valuations of these markets on fundamentals, one would have to assume that they no longer benefit from cheap money but instead have again become the efficient-market-hypothesis’ disinterested, objective, reliable, and forward-looking barometers of our economic future, and of a bright future indeed, in which apparently all our problems – cyclical, structural, fiscal, demographic- have now been solved, so that the central bankers can pack up the emergency tool kit and gold can be sent to the museum. – Well, good luck with that.

The sucker trade

In the debate last Friday, my ‘opponent’, Tom Kendall, made a very good point. Tom said that what causes problems for gold was the ‘direction of travel’ of the economy and other asset markets. It is maybe a bit of a strange phrase but the way I understood it it is quite fitting: equities are trading higher (in my view, mainly because of easy money and the correct expectation that easy money will stay with us) while bonds are stable and inflation (so far) is not a problem. In this environment, the gold allocation in a portfolio feels like a dead weight. For most investors it is difficult to stand on the sidelines of a rallying equity market. They need to be part of it.

I think that what is happening here is that Bernanke & Co, are enjoying, for the moment, a monetary policy sweet spot at which their monetary machinations boost equities sufficiently to suck in more and more players from the sidelines but do not yet affect the major inflation readings and do not upset the bond market. This policy is not bringing the financial system back into balance. It does not reduce imbalances or dissolve economic dislocations. To the contrary, this policy is marginally adding to long-term problems. But it feels good for now.

Bernanke is blowing new bubbles, and as we have seen in the past, it is in the early inflation phases of new bubbles that gold struggles. Equity investors are getting sucked in again, and the gold bugs may have to wait until they get spat out again and the Fed’s cavalry again rides to their rescue, that gold comes back.

In any case I remain certain of one thing …

This will end badly.

This article was previously published at DetlevSchlichter.com.

15 Comments

  • mrg says:

    “There are two potential outcomes (as I explain in my book): 1) This policy is maintained and even intensified, which will ultimately lead to higher inflation and paper money collapse. 2) This policy is abandoned and the liquidation of imbalances through market forces is allowed to unfold.”

    Does it really have to be one of these extremes?

    A middle route seems possible, perhaps likely: once consumer price inflation starts to take off, central bankers will cut back on their money printing – not so much that a full liquidation of imbalances occurs, but enough to prevent paper money collapse.

    • Robert Sadler says:

      Once CPI starts to take off it may be too late. We are already seeing the results of inflation in asset prices. By the time this filters through to consumer prices large increases in what the government calls “inflation” may be unstoppable.

  • Paul Marks says:

    Fiscal policy mrg – fiscal policy.

    The Welfare States are unsustainable – unsustainable in fiscal terms. So monetary policy will be used to fill the gap.

    Actually this has been going on for a long time – as the reason why the banking boom was encouraged (and it was encouraged) by governments was so that they could get the tax revenue.

    The tax revenue on credit bubble banking – to sustain their Welfare States.

    Now things have moved on – Central Banks (as you know) are creating money-from-nothing in order to finance (directly or indirectly) the deficit spending.

    The capital stucture of the economy is becomming more and more distorted – which is underming long term tax revenue (and boosting demand for Welfare State services).

    It is a vicous circle – the more they go for “cheap money” to fianance the Welfare States, the more the Welfare State burden becomes unsustainable, and the more pressure there is for more “cheap money”.

    We can all work out where all this will lead.

    As for gold…..

    The price fall was long predicted.

    The elite (political and financial) will do ANYTHING rather than accept the collapse of their system.

    They will ruin the shareholders of major financial insitutions – by doing all sorts of rigging to reduce the price of gold (and of silver). They will bankrupt banks and other financial enterprises – just to reduce the price of gold and silver (because they, quite correctly, see gold as a big threat to their system). This is a POLITICAL price fall – politically motivated.

    How long can they manage this?

    I doubt it will be long – they are not as powerful as they think they are.

    I would predict that gold prices will start going up again by the end of this year.

    • Tim Lucas says:

      Though I have no clear view on the price of gold, I agree with you, Paul Marks. The only hope is that the people are sensible and so insist through the ballot box that the government stop this course.

      It is, therefore, utterly wretched that the public is blissfully unaware of the unsustainability of its governments’ financial position as well as being vociferous in its calls for continued government spending.

      The famous one liner from Alexander Fraser Tytler says it best for me:

      “A democracy cannot exist as a permanent form of government. It can only exist until the majority discovers it can vote itself largess out of the public treasury”.

      Democracy can be just as much a tyranny as autocracy, which is why of course the founders of the United States set up their country to be a Constitutional Republic.

      • Re Tytler, I think Plato got there 2,000 or so years earlier. I think Plato thought democracy was doomed because the population would vote itself goodies that the country could not afford. But I can’t give you chapter and verse.

        • Tim Lucas says:

          Absolutely right Ralph – all laid out in Republic – though I dislike his view on the inevitability of the progression. This in turns leads him to recommend a policy of stasis, whereby we all know our place within some sort of feudal structure which he seemed to model on Sparta. In my view this is classic medicine being worse than the disease – barbarism which is the very opposite of what one ought to be fighting to acheive.

  • It seems to me that we are entering another stage in the game. They shamelessly took account holders’ money to cover debts – more or less legally and in accordance with the fact that your account balance is merely an IOU, as far as I can see. People are beginning to realise that this can happen at any time to anyone with cash in the bank. But this is not causing widescale panic, so they have largely succeeded in adding another trick to their bag of tricks in preserving the fraudulent fractional reserve banking system of fiat money which world now suffers. Overall, it is not good for gold in the short term, but is a clever new kick-the-can technique, and long term is good for gold. The Great Crash 2019 will be great for gold.

  • chuck martel says:

    Always keep in mind that every time someone sells gold, someone else is buying it. Someone else thinks that the purchase is a good idea at the price.

  • Paul Marks says:

    We will not have to wait for the “crash of 2019”

    2013 will be bad – and 2014 will be worse.

    And it will carry on getting worse.

    As for democracy…..

    John Adams said (in his “A Defence of the American Constitutions”) that without an INDEPENDENT Senate (i.e. one not elected by the people) eventually the time of politicians who would promise “the poor” the goods of “the rich” would return (return from the Classical World).

    And the independent Senate was destroyed in 1913 – the aame year as the Federal Income Tax (a tax sold as meaning “the many” could benefit at the expense of “the few”).

    At first it was actually the elite (not the public) who were filled with zeal to create “social programs” – but times may have changed.

    The words of Mitt Romney (no hardcore conservative) may prove to be true – just as the words of Cicero proved to be true (my apologies for putting Romney and Cicero into the same line).

    There are too many government dependents – it undermines chances of victory in elections.

    And remember the DIFFERENCE.

    In the Roman world “bread and games” were only given to the mob in Rome and few other cities – the vast majority of the population (living out in the country) got nothing from the state.

    Today about half the population live off the state.

    The Res-Publica will not collapse into an Empire that will carry on for centuries (as Rome did).

    It will just collapse.

    • mrg says:

      And the independent Senate was destroyed in 1913 – the same year as the Federal Income Tax (a tax sold as meaning “the many” could benefit at the expense of “the few”).

      I’m not sure a Senate elected by state legislatures can be considered ‘independent’, but until your comment here I assumed senators had always been directly elected. Interesting to find that isn’t so:

      https://en.wikipedia.org/wiki/Seventeenth_Amendment_to_the_United_States_Constitution

      I’d never imagined that an upper house appointed by the political class (as we have here in the UK) could be preferable to one that is directly elected. I am sceptical of democracy, though, so perhaps this level of indirection has benefits.

      • Craig Howard says:

        I’d never imagined that an upper house appointed by the political class (as we have here in the UK) could be preferable to one that is directly elected.

        The original intent was that the Senators would be elected by the state legislatures and function to resist efforts by the Federal government to take power away from the states. I think it was an ingenious design — one that the early progressives swiftly dismantled to our detriment.

  • CaptainSkin says:

    There is no way out.

    Fiat currencies will follow the hundreds of paper experiments of the past.

    We are going back to sound money.

    Gold, silver and crypto currencies will usher in a new era of prosperity, and ultimately, anarcho-capitalism.

    We are entering the information age…

  • Paul Marks says:

    Some Swiss Cantons had democracy (and direct democracy at that) for centuries – without this voting themselves the stuff of the rich.

    San Marino tends to have the same taxes as Italy (not really allowed to be a tax haven – in income tax and so on).

    In the ancient world Carthage (according to Aristotle and others) was noted for all citizens having the vote but NOT having class conflict (a cultural thing?).

    In the more recent past Venice went for a thousand years without revolution or civil war.

    Of course the Republic of Venice was hardly a “democracy” – it was a system of checks and balances.

    As Venice had a reputation for moral naughtyness people did not want to be seen copying its institutions.

    Although they could do a lot worse – and normally do indeed do a lot worse.

  • Paul Marks says:

    Of course Plato (a collectivist by the way) was not using ESP when he talked about how democracies are corrupted.

    He had seen Pericles (and others) at work in Athens – promising the voters X, Y, Z, at the expense – of ….. (well someone else).

  • Paul Marks says:

    mrg – at the State level things were different.

    State Senates were directly elected – but represented counties.

    The rural vote (in the State Senates) counterbalanced the urban vote (in the State Houses).

    But then the Supreme Court came along – claiming (quite dishonestly) that the 14th Amendment means that “votes must have equal weight” .

    Thus undermining the whole point of having State Senates.

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