Thursday, October 30, 2014

Gold prices in the post-QE world

Lacking a distinctive catalyst, gold prices have languished in recent weeks after a failed turnaround attempt earlier this month.  Gold’s primary form of price propulsion is fear and uncertainty; as long as investors are worried what the future might hold, gold is treated as a financial safe haven and its price tends to appreciate due to increased demand.  When investors aren’t worried, however, gold is typically ignored and risk assets (viz. equities) become the preferred choice.

There was plenty of fear to go around earlier this month: Ebola, the global economy, the U.S. stock market, and a host of other concerns.  Now that those fears have abated the equity market has regained its attraction for investors, especially after the plethora of bargains that were offered after the steep decline in stock prices.  Gold has once again been relegated to the sidelines and awaits the appearance of the next bout of investor fear and panic. 

On Wednesday the U.S. Federal Reserve announced the formal ending of quantitative easing, the long-standing policy of purchasing Treasuries and mortgage-backed securities.  Gold bugs lamented the end of QE, but the gold market long ago discounted its finale.  Actually, QE did gold little favors in the grand scheme of things.  Many commodity investors are under the mistaken notion that QE was inflationary, which manifestly wasn’t the case.  The primary purpose of QE, as economist Scott Grannis has explained, was to satisfy the seemingly insatiable demand for bank reserves and low-risk assets.  As Grannis puts it, “Without QE, there would have been a critical shortage of safe, risk-free assets, and that would have threatened financial stability.” 

Aside from the observation that QE3 didn’t really help the gold price, even if QE had been truly inflationary it’s doubtful it would have given gold much of a boost anyway.  Gold doesn’t actually benefit from inflation unless the inflation is extreme.  As my mentor Samuel Kress observed, gold tends to benefit most during the hyper-inflationary phase of the economic long wave, or 60-year cycle. 

Gold’s biggest booster in the last 14 years came primarily from two things: 1.) the fear and uncertainty of the post-911 world where geo-political turmoil and financial market volatility became regular features, and 2.) the unparalleled demand for commodities from booming Asian economies. 

China in particular was a big reason behind gold’s run to stratospheric highs.  During the boom years for China's spectacular growth in the 1990s and 2000s, the country accumulated huge amounts of foreign exchange reserves.  This led to a significant appreciation of the yuan currency, which as Scott Grannis speculates, was a major reason for higher gold prices.  

“The spectacular growth of the Chinese economy beginning in the mid-1990s created legions of newly prosperous Chinese whose demand for gold pushed gold prices to stratospheric levels,” writes Grannis.  “China's economic boom attracted trillions of foreign investment capital, which China's central bank was forced to purchase in order to avoid a dramatic appreciation of the yuan, and to provide solid collateral backing to the soaring money supply needed to accommodate China's spectacular growth. China's explosive growth and new-found riches were what fueled the rise in gold prices. But in recent years the bloom is off the rose.”

Chinese economic growth has unquestionably slowed in recent years.  China's foreign exchange reserves only increased by 6% in the year ending September 2014, while the yuan is unchanged over the past year.  Meanwhile gold prices are down by one-third from their 2011 peak.  While China’s economy is no longer booming, it’s still growing around 7% a year which is nonetheless impressive.  As Grannis puts it, “China's economy is not collapsing, it's maturing.”  

Don Luskin of Trend Macrolytics also made a worthwhile observation regarding China's foreign exchange reserves: they are closely connected to the rise in the price of gold.  He argues that the outstanding stock of gold grows at about 3 percent per year, but that the demand for gold experienced a dramatic increase in the first decade of the new century as China, India, and other emerging markets experienced enjoyed explosive economic growth.  As the demand for gold increased much faster than supply, it was to be expected that the gold price experienced a dramatic increase.  As one analyst put it, this amounted to a “one-time surge in the demand for the limited supply of gold.”

Grannis further points out that the growth in China's foreign exchange reserves was exponential for many years, but now it's slowed to a trickle.  Capital inflows have slowed, while outflows have increased.  The meteoric demand for gold ended three years ago once China's capital inflows settled down to more manageable levels.  It also coincided with the regulator’s decision to increase margin requirements for gold futures positions. 

Grannis calculates that gold’s long-term average in real terms over the last 100 years in today’s dollars is around $650/oz.  Without the insatiable demand of newly rich Asian buyers, therefore, gold’s price is coming back down to more closely track other commodity prices. 

In other words, the speculative element of gold’s price is being replaced by the value element.  And until gold reaches a price level which satisfies the world’s value investors, it will probably be a while before the next major long-term bull market kicks off. 

Rallies in the gold price between now and then are likely to be short-to-intermediate-term affairs and will largely be determined by investor psychology and technical factors (i.e. “oversold” or “overbought” market conditions).  Sustained demand of the type that fuels sustained longer-term bull markets in gold likely can only occur if either a climate of fear returns (not likely in the foreseeable future) or else inflation rages out of control (again, not likely).  So until the longer-term investment climate changes we’ll have to content ourselves with the periodic buying opportunities gold presents to us, taking profits whenever it reaches an oversold condition and awaiting the next rally. 

Wednesday, October 22, 2014

The inevitability of QE

A swan dive in commodity prices followed by the latest stock market correction has investors talking about the “D word” once again.  References to deflation abound in the news while economists seriously discuss the possibility of a global economic recession.  What, they ask, will it take to arrest the slowdown in the euro zone and China and prevent its coming to U.S. shores?  Why central bank intervention, of course!

One of the dominant themes of 2014 has been the unwinding of the U.S. Federal Reserve’s QE stimulus measure.  After purchasing as much as $85 billion worth of long-term Treasuries and mortgage-backed securities per month in 2013, the Fed was scheduled to end asset purchases this month.  With the revival of deflation fears, however, there has been some talk among Fed members that perhaps it would be wise to delay the end of QE.  Considering that the QE tapering process has clearly had a negative impact on stocks and commodities, as well as the real estate market, the suggestion to extend QE further is being seriously considered.

While there have been many negative headline events this month that have been blamed on the September-October stock market decline – ranging from overseas economic concerns to unrest in Hong Kong and Ukraine to Ebola – the real reason for investors’ worries can be boiled down to one major concern, namely liquidity.  (Remember the old Wall Street mantra: when it comes to the stock market it’s all about “liquidity, liquidity, liquidity”). 

The selling panic started just as the Fed was putting the final touches on phasing out QE.  While economists were convinced the market would be able to stand on its own two feet without the benefit of QE, investors were far less certain.  Adding to the concerns of U.S. investors were recent actions (or inactions) by the heads of Europe’s and China’s central banks which suggested that both regions weren’t committed to pursuing further monetary stimulus.  Those concerns have recently been allayed by statements by central bank chiefs in the last couple of days. 

Last week, James Bullard, head of the St. Louis Fed, said the Federal Reserve should continue with asset purchases and thus extend QE until the U.S. economy shows more strength.  “We can go on pause on the taper at this juncture and wait until we see how the data shakes out into December,” Bullard told Bloomberg Television.  “Delaying the taper is something we could do right now that could buy us a little time.”

Not everyone at the Fed agrees with Bullard, however.  Boston Fed President Eric Rosengren suggested that when the Fed meets for its Oct. 28-29 policy meeting it likely will maintain its original intention of ending QE at that time.  “The [QE3] program was really designed that once we made substantial progress on the unemployment rate and labor markets more generally that that program would end.  If it looks like we're not going to get that kind of progress now and going forward then we’d have to reconsider it, but I would be surprised if in the next two weeks we get enough data to make us change our mind on that,” he told CNBC.

Despite Rosengren’s hawkish comments, other central bank members share Bullard’s dovish tone.  European Central Bank executive member Benoit Coeure said that ECB purchases of asset-backed securities are set to begin within days, while Bank of England Chief Economist Andy Haldane stated that recent economic data “speaks in favor of delaying the BoE’s first rate hike,” according to 

Bullard also made an even more revealing statement.  “Inflation expectations are dropping in the U.S. and that is something that a central bank cannot abide,” he said.  There you have in a nutshell the entire philosophy of the Fed these last six years.  The actions of central banks, especially the Fed, are governed by the idea that a little inflation is a good thing and that inflation should even be created where it doesn’t exist.  Instead of letting prices take their natural course according to the demands of the free market, the meddlesome Fed is constantly intervening to prevent the natural cycles from doing their job and keeping the economy healthy.  This intervention does more harm than good since it tends to create artificial asset price bubbles followed by their subsequent deflation. 

The trend of retail prices on the consumer level since the credit crash is a case in point.  What should have been a bonanza for consumers with money in savings turned out to be burdensome as retail prices were artificially high from about 2010 and beyond.  Only in recent weeks have consumers finally seen some relief in the form of collapsing fuel and commodity prices.  But of course the Fed won’t allow this break to consumers to carry on for very long since the bank is intent on stoking the fires of inflation.  With any luck, though, consumers may get to enjoy at least a few months of lower retail prices before the next round of QE starts up. 

Wall Street is also keen on seeing the Fed reinstitute some form of QE.  Since money managers have gotten used to the easy stock market gains fueled by the loose money and corporate share buybacks of recent years, they’re understandably in no hurry to see it end.  They’ll no doubt push the Fed to keep its foot on the monetary accelerator in the near term despite calls from the hawks to completely end the stimulus and raise interest rates. 

The important thing for now is that investors are apparently satisfied that central banks are at least showing an awareness of the risks confronting the global economy and won’t be as quick to tighten monetary policy (which would no doubt be bad for stocks).  A recent report suggested that China may replace the current head of the country’s central bank with someone more dovish.  China’s currently tight monetary policy is one reason for its diminished gold and commodities demand.  A loosening of monetary policy strictures would surely set the wheels in motion for higher stock and commodity prices. 

Central bankers may even heed the calls of the doves and loosen monetary policy (which would be bullish for stocks, at least in the interim).  Thus the September-October stock market correction was arrested by nothing more than the reassurance that central banks stand ready to do “whatever it takes” to keep the financial system liquid. 

Global investors still aren’t completely convinced of the Fed’s intention to maintain liquidity at all costs, however.  The distrust of investors both foreign and domestic can be seen in the strength of the U.S. dollar, which has become the safe haven du jour since this past spring.  Indeed, the dollar index (above) has been in a sustained uptrend during the final descent of the long-term deflationary cycle and is stubbornly remaining near its highs.  Only when a concerted central bank monetary stimulus becomes a reality again will the dollar lose its allure.  

Friday, October 10, 2014

Revenge of the Kress Cycle

Throughout most of 2014, economists were convinced that the threat of deflation had been successfully bypassed thanks to Fed intervention.  Indeed, many celebrated economic forecasters have been loudly cheering the mostly solid-looking economic data throughout most of this year.  But as Yogi Berra once said, “It ain’t over ‘til it’s over.”

The Kress 60-year cycle of inflation and deflation, known as the Super Economic Cycle, was scheduled to bottom this October.  The bottom of the cycle may well be in, but the deflationary pressure it has helped create hasn’t bottomed yet.  If the downward spiral of commodity prices generated by the final “hard down” phase of the cycle this summer and fall isn’t reversed soon, we may end up seeing “Revenge of the Kress Cycle” coming to a theater near you. 

Put another way, the incessant meddling and intervention by the U.S. Federal Reserve in recent years may have staved off the deflationary impact of the final years of the 60-year cycle after the credit crash.  But as Mr. Kress himself was wont to say, “The Fed ultimately can’t beat Mother Nature and Father Time.”  The years of artificial suppressing the natural cycle of deflation may have created a cyclical backlash, a counter-wave if you will, that could witness a confluence of falling prices across several major financial markets around the world. 

There have definitely been premonitions of such a deflationary backlash in just the last few weeks.  One of the most conspicuous of proofs that deflationary currents are at play is the drastic decline in petroleum prices.  Consider that gasoline prices have been plunging and are now at their lowest level in almost four years. 

Since oil and gas prices are among the most important variables in determining prices of all sorts of goods, it stands to reason that as oil prices fall it will eventually lower prices on the retail level.  It has long been the observation of top cycle analysts that a failure of the oil price to decline in a meaningful fashion before long-term deflation reaches its nadir would do irreparable damage to the economy once the next long-term inflation cycle kicks off.  If retails prices enter a renewed inflation cycle at a high level, the return of cyclical inflationary pressures down the line will only serve to strain the economy in the form of higher living costs.  Seen from this perspective, the plunge in oil and gas prices is a blessing in disguise. 

Oil isn’t the only major commodity to suffer the ravages of deflation.  Prices for a large basket of commodities have continued to slide in recent months.  The Dow Jones Commodity Index has fallen over 10% year-to-date since commodities peaked in late June.  Most losses to commodity prices have come since then, which corresponds to the final descent of the Kress cycle.  Falling demand and prices for commodities has hurt countries which rely heavily on industrial exports, including China and many European countries. 

Europe’s economic powerhouse Germany, for instance, has been particularly hard hit by the sanctions imposed upon Russia in the wake of the Ukraine crisis.  Manufacturing orders for Germany dropped 5.7% in August, which is the lowest level in over a year.  The country’s industrial production plunged 4.3% in August to the lowest reading since January 2013, according to Ed Yardeni. 

In the wake of these recent developments, economists have modified their forecasts and are predicting deflation in the euro zone as EU monetary policy remains tight.  ECB president Mario Draghi has made attempts at raising prices by hinting at a U.S. Fed-style QE initiative, but so far his plans have been stymied as policy makers in Germany refuse to endorse it.  For now the European Union remains mired in an economic malaise with no stimulus effort on the immediate horizon.

Assuming Mr. Kress’s dictum that “the cycles will always prevail” is true, let’s examine some possible scenarios for the final resolution of the long-term deflationary cycle.  The first possibility is that of a Kress cycle compression.  Simply stated, this scenario would mean that most of the deflationary damage has already been done and that the short-term will only witness some residual damage, followed by gradual recovery in equity prices as well as oil prices. 

The next possibility is that of a Kress cycle inversion.  An “inversion” is a term used by Mr. Kress to describe what happens on rare occasions when a major cycle bottom essentially transforms into a top, leading to an extended decline beyond the time frame of the original cycle.  An example of this was seen in the final stage of the credit crash of late 2008.  While the worst of the damage was seen in the third and fourth quarters of 2008 when the 6-year Kress cycle was bottoming, there was additional spillover damage into the first quarter of 2009 before stock and commodity prices put in their final lows.  The (temporary) failure of the 6-year cycle bottom to reverse the downside momentum in late 2008 was due to a lack of confidence among market participants.  It took reassurance from the Fed and from Washington in the form of massive stimulus before investors felt confident enough to commit to buying once again. 

Currently, investors are perhaps waiting for the U.S. elections next month before making major commitments in the financial market.  Meanwhile, foreign investors aren’t budging until they see the promised stimulus efforts from Europe’s central bankers and policy makers.  If this “wait-and-see” attitude persists it could give credence to another Kress cycle inversion, just as it did in 2008.

The market may also be waiting to see if the Fed reverses course on its stated intention of raising interest rates sometime next year and instead introduces more stimulus measures if the deflationary pressure continues.  Certainly much more in the way of stimulus is expected of Europe’s and Japan’s central banks, and aggressive policy actions from both regions will likely be seen in the coming months. 

Meanwhile there is a growing realization on Wall Street that perhaps the winding down of the Fed’s quantitative easing initiative was premature.  If the Kress cycle inversion scenario is realized and prices continue to slide, the Fed will be confronted with the possibility that emergency stimulus measures are needed to reverse the damage and prevent full-blown deflation. 

If recent market developments have done nothing else, they have proven the celebrations of economists and pundits over the “death of deflation” to be woefully premature.  Before the Fed’s vision of a return to “normal” inflation can be realized, it’s clear that more work lies ahead.