One of the scenarios I did not consider in my longstanding bullishness on gold is that the bond market might actually rise up AGAINST the wishes of the Federal Reserve. If the Fed actually loses control of the bond market, and increasingly this seems to be the case, I expect gold (NYSEARCA:GLD) to continue to lose its luster as the psychology of deflation transitions into an assumption that higher yields are finally on their way to pricing in future inflation (or inflation risks).
The recent surge in yields now appears to be part of an extended bottoming process
Source: The St. Louis Federal Reserve
TLT gets slammed - trading at levels last seen in September, 2011
If long-term rates are bottoming, the coming transition period will be a kind of moment of truth for us "gold bugs". However, I am not yet convinced that rates are now on an upward trajectory….and not just because the folks over-crowded into the "safety" of bonds are not yet ready to take on massive losses. And ultimately, the direction for gold will depend on the direction of the U.S. dollar (NYSEARCA:UUP) - which should ultimately return to a downward trend.
Through all the blustering hype about bond tapering, Federal Reserve Chairman Ben Bernanke made clear in his last statements on monetary policy that the Fed still has the same rules for tightening policy it established back in 2011, and it has no intention of tightening policy any time soon. The current economic recovery is not strong enough to warrant a tightening in policy. In fact, the Fed wants to keep monetary policy loose for some time even after a recovery appears to finally be firmly in place. Yet and still, interest rates continue to hike further as the market attempts to price in some change in policy and/or economic prospects. Ironically, with unemployment still high and a housing market that is only a about a year into a bottoming process after years of depression-like conditions, much higher rates are almost certain to force the Fed to consider measures to push rates back down. It is a sign of our exceptional times that the bond market's economic signals are so distorted.
Fundamentally, I believe what has happened is much more a change in market psychology and sentiment than a real change in policy or economic growth. The likely implications of this change in psychology are tremendous for gold (and silver). This sharp and sudden jump in rates driven by this sentiment represents the fear of deflation finally starting to recede from the bond market. It is partially this fear that has motivated (even required) the Fed's extraordinary monetary measures. These measures have in turn motivated us gold bugs to look further into the future and envision a day where the Fed loses control of inflation because of a willingness to maintain extraordinary measures long after the economy is on a firm path of recovery. The Fed's reluctance to act swiftly will come from its own fear that moving too fast would send the economy right back into a deflationary funk. Some gold bugs maintain other fears that I do not share; I am primarily focused on this one locus of risk.
Having this singular focus means I am more pragmatic than dogmatic about my bullishness on gold. However, the history of the U.S. dollar (and paper currencies in general) is one of on-going debasement, so gold and silver will remain attractive. Changes in market sentiment like the current one just change the outlook for the path of price movements, not the ultimate direction. Thus, the current sell-off has me salivating. I am eagerly taking advantage to accumulate the larger position I have wanted since I greatly reduced my trades in and out of gold and silver in order to simplify the management of the portfolio. That time was about two years ago and at the time I was afraid I would one day sell out of a position only to find myself under-invested in the wake some parabolic move higher.
We gold investors have had it relatively easy for many years now. Gold haters constantly called tops with every rally, and we would scoff and take great comfort in the next resumption of the rally. The broken clocks finally got it right in 2011 as gold made a "mini"-parabolic move to what now stands as a lasting high. Until the major breakdown in mid-April of this year, it appeared as though gold would hold important support levels, consolidate, and launch its next phase higher. Instead, gold has suffered two additional breakdowns, both in the last week and a half.
A major breakdown for gold
A cascade of breakdowns
There are several interesting characteristics of gold's cascade downward. The first observation is that gold's dramatic moves are not matched by any dramatic moves in the U.S. dollar. On the way up, gold disconnected from the U.S. dollar when the currency stopped its steady decline in the wake of the 2008/2009 financial crisis. While gold is trading at three year lows, the U.S. dollar index is simply meandering in a type of range roughly established by its levels when QE2 and QE3 became known quantities. When gold peaked in 2011, the U.S. dollar index was returning to multi-decade lows. The ignition of the worst phase of the crisis in the eurozone made the U.S. dollar popular again, and it has not yet looked back.
The quarterly view shows the dollar index's historic low ahead of the crisis and the trading range since then
The dollar index has been bouncing in a tight trading range since 2012
I particularly like the long-term view of the dollar index. This view is a great reminder that it was only the financial crisis that ended the dollar's secular decline. Even more important, the dollar index has not established a new trend since then. It has gyrated up and down with changes in monetary policy and the perception of risks in the global economy. These fluctuations overall amount to a lot of noise. In the midst of this noise, gold continued its rally. In the midst of this noise, gold is now sharply selling off. I have no idea when or how trends will get re-established, but in all this noise, I prefer the option of accumulating at better prices.
Another interesting characteristic of gold's gyrations is the consistent ability of Google trends to signal major buying moments. In the past, I have called looked for bottoming signals, but it is more precise to distinguish them as buying (or selling) moments. Right after April's breakdown, I pointed out how "gold enthusiasm" hit a historic high. That enthusiasm signaled a bottom that lasted two months, including once successful retest of that bottom. Once might call these short-term bottoms. Whether or not the market finds a lasting bottom depends on a whole host of other factors that must last over time. In other words, sharp changes in gold enthusiasm may predict sharp changes in the buying/selling bias of the market, but it says little about how long that change will last.
As a case in point, gold made a one-day, 180-degree turnaround as it surged off major lows to end a brutal second quarter. Google trends for "buy gold" (the blue line) surged the day before in the wake of major selling while "sell gold" (the red line) continued its meandering.
Spikes of interest in buying gold have come in the wake of major sell-offs and major bounces
Source: Google Trends
For perspective, here is the chart for Google trends that shows the major high from mid-April (it also washed out the much smaller spikes in June). When I last showed this chart, I thought the spike in April matched the historic high from August, 2011 and that the spike was cut off by the graph. This view makes it clear that April's spike was the third highest in history, not the very highest. Regardless, the primary lesson remains the same: a spike in interest in "buy gold" that is not accompanied by a spike in interest in "sell gold" still appears to forecast an immediate buying moment. Spikes in both terms (just two in this history) accompany a major change in the prevailing trading bias. Google has also added a forecast function. If we believe it, it suggests that at least one more spike in buying interest is coming in the next few months.
A history of surges in buying and selling interest in gold
Source: Google Trends
My stylized gold enthusiasm index, the Google Search index divided by the price of GLD multiplied by 100, has also spiked as a result of the spike in buying interest. Note that April's surge ranks as the second highest in this series.
Gold Enthusiasm Spikes Again
The "price" of the S&P 500 (NYSEARCA:SPY) in terms of gold has also finally picked off its historic lows. Gold bugs look at the following charts and see a temporary blip, nothing but noise. Gold haters see the beginning of a major comeback in the S&P 500…maybe even back to the index's bubble levels versus gold.
The S&P 500 remains at major lows versus gold…
…despite the recent change in fortunes
Source for gold prices: World Gold Council; source for S&P 500 and GLD prices: Yahoo!Finance
For perspective, remember that the S&P 500 is just a few points off its all-time highs when priced in nominal dollars. Listening through all the current noise remains, and should continue, to be the solid winner.
In my next piece, I will tackle the bane of almost every conversation about the value of gold: quantitative easing. Gold bugs have overstated the case. Gold haters have blithely ignored the risks. Somewhere in between, remains the very solid case for keeping a tight grip on your gold, ignoring the noise, and accumulating at cheap prices…
Until then, be careful out there!