I don't think it's much of a stretch to say that the gold (GLD) market is entering a zone where a major decision will have to be made by bulls. Last week's washout near the $1,550 level was unexpected for this month given the extremity of the move so far, but the extreme weakness in the euro would not be overcome. As I have been trying to establish in my previous articles on gold the day-to-day price movements are governed by a complex interplay of a number of factors -- including short-term inflation expectations and the demand for Brent crude (BNO) -- but the biggest one is gold's link to the euro (FXE). So, in many ways, an attack on the euro is an attack on gold.
The question is: Which one is the driver, and which one is the passenger?
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I believe that gold is the driver of the Fed's actions not the euro. Punishing the euro is a beneficial side effect. But demand for the euro is the fulcrum that can be leaned on to drive the gold price in the direction desired by the major central banks. One must remember that gold lies at the bottom of Exter's Pyramid and, as such, is the most important instrument in determining the health of the central bank's balance sheet.
The ECB marks its gold to market, meaning that the ledger entry for its gold reserves rises and falls with the price of gold. As the price of gold or the quantity the ECB holds rises, the more the ECB can expand the base money supply.
The Fed, on the other hand, holds the U.S.'s 8133.5 tons of gold on its balance sheet at $42.22 per ounce. So, never forget this basic point. The Fed and the ECB are at odds in terms of how they can deal with the weakness of their banking systems. When the Fed bails out a bank it has to expand its balance sheet without improving the quality of its asset structure. Since Lehman Bros. the Fed has moved its balance sheet up Exter's pyramid trading Government bonds and Treasury Bills for derivatives like mortgage-backed securities and other synthetic products.
The ECB has been moving down Exter's Pyramid, not by buying gold but by getting the nations that it bails out to pledge their sovereign gold holdings as collateral for the bailout. This happened in Greece and it is very likely why Spain and Italy have resisted asking for a bailout under the OMT facility.
So, when I look at the latest round of bearish euro news all I see is the natural consequence of the ECB applying pressure in the form of a shrinking balance sheet and liquidity to force a resolution. Spain and Italy are facing the same choices that Greece did.
- Leave the euro, reinstate a local currency and devalue it to pay off bondholders, flush some of the banks and start from scratch.
- Stay in the euro, ask for the bailout, suborn its sovereignty to the European Union via the ECB and hand over its gold reserves as collateral for a loan it cannot pay back.
Either way the euro wins. It either rids itself of a bankrupt and profligate member state or it gets a massive injection of high-powered reserves to use to back the currency. The European Commission refuses to entertain the idea of a nation leaving the euro -- a kind of monetary "Hotel California" -- therefore the policy will be to squeeze the member states into submission, human dignity be damned.
The Proxy War
The big story of the past three months has been the 17% depreciation of the Japanese yen (FXY) vs. the U.S. dollar. But, that's really only half of the story. The depreciation vs. the euro through the beginning of February had been 30%. And this is where the story gets a little complicated.
To attack gold fundamentally in the face of the Fed expanding its balance sheet rapidly to pay for the current fiscal budget deficit there had to be a mechanism to stimulate international demand for dollars because, as I said in my last article, the rest of the world stopped buying U.S. Treasuries. The latest TIC report is very clear on this. Moreover, the petrodollar system is failing as more and more oil is bought directly without needing to convert local currencies into dollars before buying oil. So, in the aggregate international demand for dollars has been dropping. A rising oil price is needed to continue the flow of dollars.
The Japanese began printing up a metric ton of yen and used those yen to buy dollars. Bond prices fall in response to higher demand for dollars. This goes on the entire time the yen is falling. With gold under pressure during the run-up to the fiscal cliff, this added demand for dollars is natural and the uncertainty of future capital gains taxes sees gold sold into the end of the year.
Since the yen's devaluation began on Nov. 15, the correlation with the ten and the 10-year U.S. Treasury yield has strengthened considerably. This shows quite clearly the effect of the yen debasement's effect on demand for dollars. The correlation between the yen and the 10-year U.S. Treasury yield (TLT) improved dramatically once the announced debasement policy was announced by the Abe government.
2013 opens with more yen debasement and renewed selling of U.S. Treasuries. Bond yields on the long end of the curve rise because the Fed can no longer buy in the open market, legally being limited to owning 70% of any one issuance. That job will now have to fall to the primary dealers and Japan, but Japan is buying U.S. dollars. After the fiscal cliff is averted, money tries to flow into gold but a sharp drop in the euro stymied it in a violent correction on Jan. 2 and 3. The euro gains ground on the dollar as it should, since the Fed is inflating and ECB President Draghi makes it clear he's not going to be joining the printing party on Jan. 9.
China is happy with this arrangement because the euro rising allows the Chinese central bank to hold the yuan steady vs. the dollar since it is falling quickly vs. the euro, boosting exports. In fact, the eurozone should have been delighted with this scenario as the strong euro was a boon to their struggling economies, as energy and Chinese exports could flow into Europe on the cheap.
At the beginning of February, the yen stopped falling vs. the euro and the dollar. The euro began to drop as solvency fears began dominating the headlines again. The swift correction in the euro is what has the gold price under heavy pressure. And it will remain that way until the euro builds a new base between $1.32 and $1.35.
All of this is an elaborate attack designed to raise the dollar, allow bonds to fall slightly and trash gold and the euro at the same time, while forcing China to buy U.S. Treasuries or risk swift appreciation of the yuan. Brent crude is the key to the economic reality that exists outside of currency pair manipulation.
The gold-to-Brent-crude ratio is approaching an extreme condition at 13.5:1. Oil is the one commodity that does not fit in Exter's Pyramid. It is too close to the backbone of the global economy, and its trade, like gold's, is tied directly to the currency markets. This is why the Brent-to-gold ratio is so important to understanding what is really going on. Where did this sudden supply of gold come from in the past month? Why has the gold-to-Brent ratio been collapsing since the QE IV announcement back in early December?
Simple. With the petrodollar system breaking down, the only way to keep the slowing marginal flow of dollars from creating an avalanche is to allow the dollar price of oil to remain high along with artificial dollar demand created by the yen debasement. This suppresses the dollar price of gold and does the heavy lifting for the Fed to create the strange scenario of unsterilized QE, causing gold and commodities to drop.
The oil producing countries that get paid in gold absolutely love this situation. I have to wonder about a scenario that sends gold at a 15% discount into Iranian and Russian hands. It beggars logic to think that this is 1) desired by the U.S. and its allies, and 2) sustainable. The gold-to-Brent ratio will not stay at these levels for too long. It will create too much real physical demand for gold per unit time, which will necessarily overwhelm the paper markets. Meanwhile Japan will go broke faster paying for oil at prices it couldn't afford at ¥75 no less ¥95 or ¥120, as has been suggested.
This tells me that we have reached our decision point in gold -- and, by extension, silver (SLV). The FOMC will either have to put up or shut up about QE and interest rates -- if not now, then soon. They can play games with the headlines and foreign exchange markets for only so long before their bluff is called.
Additional disclosure: I own physical gold and silver and a few goats.