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Note: This essay first appeared in the June edition of USAGOLD News, Commentary & Analysis. It expands on the thinking in my previous post for those of you who like a more detailed approach to the divergence mentioned. It also goes to the heart of the matter by charting and explaining the direct connection between quantitative easing and a rising gold price. Postscript 2 is a new add-on to the original essay. (With thanks to Pete Grant for the heads-up on Mr. Gundlach's thinking as posted in his highly-regarded Daily Market Report.)

Why 2013 could be the best year to buy gold since 2008

Quantitative easing, the oft-referenced $85 billion per month shelled out by the Federal Reserve, comes down to the purchase of two kinds of securities - U.S. Treasury paper (bonds, notes and bills) and mortgage-backed securities. The Federal Reserve buys the Treasury paper from the federal government and the mortgage-backed securities from commercial banks. The first is a direct form of monetization (money printing); the second is an indirect form since a good portion of those funds is in turn also used by the banks to purchase Treasury paper. The two together comprise the bulk of what appears on the Federal Reserve's balance sheet as "reserve bank credit." At present, that figure stands at just over $3.2 trillion - up about $2.4 trillion since the beginning of the financial crisis in late 2008.

When you superimpose the gold price over reserve bank credit on a chart, it looks like this:

(Click to enlarge)

At first glance, it looks like reserve bank credit and the gold price are correlated, but what is really going on with this tandem is that they are both being pushed by the same force - a bad economy. It causes the Fed to print money and investors to buy gold.

The Financial Times ran an editorial the other day explaining why some top-notch hedge fund managers - like Paul Singer, John Paulson, Stanley Druckenmiller and David Einhorn - don't like the U.S. Federal Reserve or Chairman Ben Bernanke, the father of the QE policies charted above.

"His [Druckenmiller's] concern," the editorial explains, "is not the risk of inflation, which has prompted investors such as Mr. Singer and John Paulson to load up on gold. Instead, it is a broader concern that has been voiced by growing numbers of the most powerful and influential professional investors: that by pushing down interest rates and buying up government bonds, the Fed is warping the norms of economic behaviour."

Most importantly capital, according to this group, this misallocation of capital has driven ordinarily risk-averse investors into dangerous financial waters. "What kind of entity," warns Seth Klarman, another hedge fund manager, "drives the return on retirees' savings to zero for seven years in order to rescue poorly managed banks? Not the kind that should play this large a role in the economy."

It is these kinds of distortions, though, that create opportunities in investment markets, which leads me to the reasons why I went to the trouble of compiling and publishing this chart:

First, reserve bank credit has gone vertical since November's near-term bottom - up over 15%. The Fed might reverse or moderate its purchases at some point in the future, but at the moment, it has the pedal to the metal. While Ben Bernanke couches his rhetoric and keeps the markets guessing, he quietly - in reality - engages the Fed what could be a new round of quantitative easing. In short, the markets should be paying attention to what the Fed does, not what it says.

Second, the gold price, as a result of its recent plunge, has crossed decisively under the reserve bank credit trend line. The two developments together have made for an interesting chart divergence - the sort of thing that catches the attention of technicians and value investors alike, particularly if it defies logical explanation. This latest correction, more than any I can remember, has the experts scratching their heads. (Please see "Illogical dumping" below.) When an upward or downward spike in the market proceeds sans logical underpinnings, a snap-back rally or correction often follows. The last such incident in the gold market occurred in 2008. The market sold-off roughly 30% at the height of the financial crisis, and then regained and superseded those losses before 90-days had elapsed. (From there the market climbed to all time highs in 2009.)

Third, should the quantitative easing program finally ignite price inflation, we might see an entirely different chart pattern emerge - a different kind of divergence. Gold could go vertical while reserve bank credit stays level or heads south depending on the Fed's ability sell off the securities it accumulated during the quantitative easing stage.

That same Financial Times editorial concludes with this important observation on the behavior of hedge funds and hedge fund managers:

"'Part of the pressure comes from knowing, or sensing," says Richard Fisher, president of the Dallas Federal Reserve, "that at some point you are going to get a reversal. If I was in my old business I'd be looking around [asking] how am I going to make money without taking undue risk?' It is a big problem for the masters of the universe. They live for distortions in markets, which provide them with opportunities to throw billions of dollars at a brilliant trade that will push prices back in line with reality. Successful hedge fund managers make their reputations by being clever, brave or fast enough to seize on these chances."

One of those distortions looks like it may have materialized in the 2013 portion of the gold-reserve bank credit chart. The press greatly emphasized the withdrawals at the gold exchange traded funds over the past several months. What it failed to mention is that there are two sides to every trade. Someone was selling, but someone else was buying (and I'm not talking about just Chinese mothers and Japanese housewives). Even now the gold price has rallied off its lows and someone is buying the mini-corrections we have seen since the big dump in April. If the longer term pattern on our chart reasserts itself, a significant upward adjustment in the gold price could be in the cards - a change of course that could end up making 2013 the best year to buy gold since 2008.


Postscript 1

Illogical dumping raises questions about causes of metal's sharp decline

"So extraordinary was the 9.4% collapse on April 15, wrote Howard Simons of Bianco Research at the time, that the odds against such a move were 20 trillion to one - 'a lower probability of occurrence than randomly selecting a [particular] $1 bill out of pile of singles representing the U.S. national debt.' These improbable moves have made gold bugs suspicious, which isn't unusual. Folks who own gold do so because they don't trust the status quo, especially when it comes to government-issued paper money. But just because you're paranoid doesn't mean somebody isn't out to get you. They point to bursts of selling on Friday, April 12, which resulted in prices plunging by more than 5%, and to dumping that resumed the following Monday in Asia, early in the day when markets are illiquid. That culminated in a 9% collapse by the time the New York market had settled. But a seller who wanted to unload a large position at the optimal price would have done precisely the opposite liquidate as discreetly as possible. Instead, sellers dumped the equivalent of more than 300 tons of the metal in staccato-like blasts during those sessions." - Randall Forsyth, Barron's, This time, the gold bugs may have a point, 5/18/2013

Postscript 2

The real reason for quantitative easing

"They know the stock market is addicted to quantitative easing. What they don't talk about that I believe, is that quantitative easing is a means to financing the budget deficit. The reason they talk about tapering quantitative easing is that the budget deficit is going to be smaller. It might come back again, because absent policy change on entitlement programs, the budget deficit is going to explode higher again in two years. They're creating the flexibility to match the quantum of quantitative easing with the size of the budget deficit. That's what's happening." - Jeff Gundlach, DoubleLine Capital

Above I cautioned that we should pay attention to what the Fed does, not what it says. If Gundlach is right, and I think he is, we should regard the government debt situation as the principal driver for quantitative easing, not the unemployment numbers. Once that is done, a haunting realization creeps into one's consciousness: One can anticipate a reversal in the unemployment numbers at some point down the road, while hardly anyone believes the parade of federal government deficits is likely to end anytime soon. That factoid, more than any other, explains why the Bernanke Fed is so obtuse, contradictory, and in fact, opaque on the future prospects for quantitative easing. Such realizations explain why Germany is repatriating its foreign-held gold reserves and why China and Russia are on long-term programs to domesticate and monetize production from their mines. They know all too well the consequences of money printing and how one goes about defending against it. Private investors might take note.


Caveat/Disclaimer: This essay is provided for informational purposes only and should not be taken as investment advice. USAGOLD does not engage in short-term trading advice, nor do we encourage speculation. We believe gold coins bullion should be purchased in physical form as long-term safe haven.

Source: The Connection Between Quantitative Easing And The Gold Price