A couple of weeks ago, I wrote an article on reasons to be bullish on gold (NYSEARCA:GLD) (NYSEARCA:IAU) this quarter. The timing could not have been worse as gold recorded its worst 2-day decline in 30 years. I have generally been bullish on gold, but the recent rout in the commodities has got me thinking if I am wrong. Over the last few days, I spent time reviewing the reasons for gold's parabolic rise over the past few years, and also looked at the last time gold fell this much in the space of a few months. In this article, I will consider an alternative scenario that gold's decline could be pointing to, which, if true, could have dangerous implications for the US economy.
If you have been following gold over the past few years, you would recognize the chart above as one of gold bulls' (and at one point mine too) most favorite charts. The monetary base is often overlaid with the gold price to make the prediction that this correlation would continue and gold should make new highs as with the monetary base. However, what's forgotten is that the monetary base in of itself does not drive gold higher; it is the fear of inflation and the debasement of the fiat currency that spurs gold higher. That is why gold has shot up after multiple announcements of the Fed's QE program. However, a couple of months ago I wrote an article in which I explained that gold's reaction to the Fed's latest round of quantitative easing is not very exciting. I argued that after the first two rounds of QE failed to bring about any real concerns about inflation, this time gold is getting a little suspicious of the promised currency debasement and inflation from printing all this money. However, I was still bullish on gold because I believed in common economic sense which dictates that printing excessive money results in inflation. But now, I'm having my doubts. Here's why:
The chart above shows the Y/Y change in the Core PCE price index, the Fed's preferred measure for inflation. You can see from this chart that the latest round of QE is having absolutely no effect on the Core PCE index; it has been dropping hard and shows no signs of stopping. This begs the question: why is the core inflation going down despite the Fed pumping $85 billion into the economy every month? In my view, the recent rout in precious metals and commodities in general, reflects the investors' increasing fears that we might be in a deflationary environment and the Fed's efforts to prevent deflation are starting to fail. Remember, it's not only gold price that has been falling. In the past three months, Copper (NYSEARCA:JJC) has lost 16%, Crude oil (NYSEARCA:USO) 9%, and Silver (NYSEARCA:SLV) 27%. The last time gold fell this much was back in 2008, dropping around 20% from August to October, and that too was due to fears of deflation due to the financial crisis, before it started rising again after the announcement of Fed's QE. This time round, the fear is that if these deflationary fears are real, the Fed won't be able to do much more to prevent it because it is already all-in.
Below is another chart which supports the deflation fears:
Despite the monetary base making all-time highs with the latest round of easing by the Fed, the velocity of the M2 stock continues to make new all-time lows and is now 4% below its 1964 low. And the relentless decline in the velocity shows no sign of stopping. Most gold bulls, me included, were of the view that the velocity of money must turn up eventually given the Fed's excessive money printing, but right now gold and other commodities are showing that the most of the bulls have lost faith, and are not ready keep waiting for the velocity of money to spike up.
So What Now?
The recent events put me in a very difficult position with respect to my view on gold. I have always believed that the sooner or later, the trillions of dollars of stimulus from the Fed would generate strong inflationary pressures which could very well spiral out of control, and gold would be the best investment in such a stagflation scenario. However, the charts for Core PCE Index and the velocity of M2 show that the core of the US economy still remains very week and the deflationary fears could be real. And the rout in commodities in the last few weeks further adds to my concerns. However, part of me still believes that Bernanke and co. would rather start dropping dollar bags from helicopters than see deflation, and that is why I have still not sold my physical gold and nor do I have any intention of selling it. I believe that if the downtrend in commodities continues and gold makes a new low, that would be a very dangerous sign for the US economy because that would signal that the commodities markets are pricing in deflationary risks. If commodities move lower, the equity markets (NYSEARCA:SPY) will start to sense the deflationary risks as well and move sharply lower, and I can say for sure that Bernanke and co. wouldn't want that and would be willing to go to any extent to prevent equities from falling. That is why I remain bullish on commodities in general and gold in particular. However, I would be closely watching the Core PCE, the Velocity of M2, and overall commodity prices in the next few months for signals of deflation.
Additional disclosure: I own physical gold.