Although I am bullish on precious metals, I am by no means one of those conspiracy theorists who believe that the worlds’ Central Bankers are colluding to suppress the price of gold. Those who believe the Central Bankers are smart enough to orchestrate such a scheme are giving them way too much credit.
I sit squarely in the Occam’s razor camp when it comes to explaining most market action. In fact, after years of watching the markets, I have even become more of a Hanlon’s razor convert. This adage is summarized as;
Never attribute to malice that which is adequately explained by stupidity.
And make no mistake, I think that when it comes to government policy, the supply of stupidity is unlimited.
So if I don’t believe that the world’s Central Bankers are sitting in an Austin Powers Dr. Evil lair plotting the demise of gold, then why is it going down?
Dr. Evil plotting to send gold to sub $1,000</a> </div></p>
To understand why gold is going down, I think you must first understand why it went up.
Let’s have a look at the trading in gold since the 2007/8 credit crisis.
Gold trading since the credit crisis</a> </div>
In the after math of the 2007/8 credit crisis, gold dramatically out performed other risk assets. Here is the chart of the S&P 500 vs gold for the first couple of years coming out the crash:
Gold (yellow line) vs S&P 500 (white line)</a> </div>
It is amusing as gold was ramping up over 100% in the course of 2 years, there was not a peep out of the conspiracy theorists about the manipulation of gold. I guess jamming the price higher is smart investing, while pushing it lower is manipulation.
Let’s think back to this time and try to remember what was going on in everyone’s mind. The Federal Reserve had moved interest rates down to zero and embarked on the biggest quantitative easing program ever imagined. Stocks were still viewed with skepticism. The economy was mired in a funk that showed very little traction. The overwhelming consensus was that the Fed was pushing on a string and that they were powerless to kick start the economy. Given this belief, investors flocked to gold and other hard assets to protect themselves against the extremely easy monetary policy.
Some attribute the rise in gold as a hedge against inflation. They argue that the gold bull market has rolled over because inflation has failed to materialize. I think this logic is far too simplistic.
Gold is a hedge against inflation, but that is only half the puzzle. The real driver of the gold price is the level of real rates (the nominal rate minus the inflation rate). During 2009–11 the price of gold rallied 100% in the face of a sub 2% inflation rate. Clearly then inflation was not the only factor driving the gold rally.
During that time, the level of real rates was plunging. In the short end the Fed had put rates to 0% so that if there was any inflation at all, the real rate was negative. Even at the long end, the real rate eventually went negative.
US 10 Year Real Rate (nominal yield minus inflation)</a> </div>
If you have inflation at 5%, but interest rates at 10% then gold is not attractive as an investment. You can earn a real yield after inflation in the risk free government market, so there is very little attraction to an asset that yields zero. But if you have rates at 1% and inflation is running at 2%, then gold is much more attractive. In this case, the real rate of return for other risk free assets is actually negative, so gold is a very enticing alternative to preserve wealth against the financial repression.
At its core, this is why the gold market rallied so hard following the 2007/8 crisis. The Federal Reserve and other Central Banks pushed rates deep into negative real rate levels. Investors flocking to gold was a natural outcome from this action.
Gold (yellow line) vs US 30 yr real rate</a> </div>
During the last big gold bull market in the late 1970’s the public became infatuated with gold. There was a rush to buy physical gold as a way to protect against the soaring inflation.
But this time, there was nowhere near the same public mania. Although there was very little public euphoria, there definitely was a bubble amongst the hedge fund community. I can distinctly remember the GLD ETF being the number one holding amongst hedge fund managers. The supposedly brilliant managers that had nailed the 2007/8 real estate credit collapse like John Paulson, stuffed their portfolios full of the shiny yellow stuff. Shifting through my research library, I came across an article I saved in October 2010 that was titled “Is the Gold trade crowded?” The article epitomized the hedge fund thinking at the time. Although they were aware that many hedge fund managers were excessively long, gold’s rally was still minuscule in the grand scheme of the massive monetary expansion. At this point, Paulson already owned $3.4 billion of the GLD and as gold’s rally accelerated in the following months, this type of thinking only became more convincing.
The strategist Don Coxe once testified in front of Congress that they should not allow the creation of the GLD ETF because it would make gold investing too easy. The GLD ETF would simply become another stock market product that investors could punt around, instead of gold being a store of value.
And this is what I believe happened. The gold trade simply became too popular. Gold should have never gone to $1900. It was one of the mini-bubbles created by the Fed’s ZIRP and QE policies.
Here is the chart of the Gold price versus the outstanding units of the GLD ETF:
Gold price (white line) vs GLD Units outstanding (yellow line)</a> </div>
The gold bull market of the 2000s was made all the more frothy by the ease in which investors could easily access the gold market via ETF.
I would argue that without this ETF product, the bull market would have never been so bubbly, and that gold would have never gotten to $1900.
The bear market of the last couple of years is simply the hangover from this mania.
Fast money investors were simply way too exposed to gold and we are in the process of cleaning them out. There is a saying on Wall Street that bear markets are when assets return to their rightful owners. That is what is happening now. The Paulsons of this world are being forced out of their over leveraged bets on gold.
It is also no coincidence that gold has been especially heavy over the last year as real rates went firmly positive in the long end of the curve.
However, over the last few months we have seen rates retreating, thus bringing down real rates. It is no surprise that the number of GLD ETF units outstanding has stopped going down, and in fact has seen some upticks recently. Western investors are responding to the lower real rates by increasing their allocation to gold.
Yet even though real rates are falling and investors seem to be once again buying GLD (or at least selling less), the price of gold keeps falling. Why is that?
My theory is that China is having more difficulty than we realize. I have not spoken about the Chinese demand at all, but it is important to realize that as hedge funds puked out their gold into the 2013 year end, the Chinese were aggressive buyers.
Since then I believe the Chinese economic (and more importantly their liquidity) situation has deteriorated. At the margin, we have lost the big buyer from China. I know that their Central Bank is still buying gold – I am only talking about the “at the margin” buyer. But all assets are priced at the margin, so this withdrawal by the Chinese consumer is hurting the gold price.
This is why gold continues to struggle even though the fundamentals seem to be getting better.
Now in the longer term, I am not that fussed about the recent gold price weakness. I think that China will return to supplying the market with liquidity. At that point, the Chinese consumer will once again be a buyer of gold. With the change in government in India, we should very soon see the lifting of gold import restrictions from that country. This will be another at the margin buyer. And finally, I believe that the gold selling from Western investors has finally finished.
Although the price action seems scary, I think that gold (especially versus other financial risk assets) is especially attractive. I don’t think that gold is going down because of some giant conspiracy. It was simply too bubbly and we needed to shake those bulls out of their positions. Unless you think that the Fed and other Central Bankers are about to push real rates into firmly territory by cranking rates, I think you need to own some gold in here.