Gold's Outperformance: This Time, It May Really Be Different

Includes: GLD
by: Robert P. Balan


There are signs that gold may be performing differently this time around, compared to the other past recovery episodes, which eventually disappointed.

The ratios of gold over other commodities or over commodity indices are outperforming, suggesting that the gold rally could partly be an offshoot of the current global financial turmoil.

There are signs that global central banks are set to expand their FX reserves soon, and as the USD is weakening, their balance sheet strategy may again include gold accumulation.

Writing an article that is positive to gold is not comfortable, given the many times the yellow metal has disappointed investors. For instance, gold prices peaked in September 2011, but then, there was a tremendous start in 2012, gaining more than +14% through January and February. By year-end, gold was well off of its late February highs. In 2013, gold traded sideways, with a weak year-end close. Gold started 2014 again with a rush, the first quarter had gold rallying by plus +14% to a peak at circa $1,400 per ounce. But Gold ended the year below $1,200. We saw the same pattern from January last year -- gold added more than +10% to just above $1,300, only to end 2015 beneath the $1,100 per ounce level. Now, it is early 2016 -- gold has risen from circa $1050 in November to near $1200 this week -- will it be more of the same sad story, or is it really different this time?

We ask the question with some trepidation because the gold price has not yet broken out of the technical structure - a "descending wedge" - that has trapped it for almost three years (see chart above). Many technical analysts consider that kind of break-out a trend reversal signal, and very positive for gold prices. It makes more sense therefore to wait for a break-out to become fait accompli before tackling gold, but then there would be little point in asking (and expecting answers) to the rhetorical question we posed. But indeed, there are signs that gold may be performing differently this time around, compared to the other past disappointing recovery episodes. The change is immediately apparent within the precious metals sector, which has been collectively beaten down by the continuing US dollar strength. Most of the components of the PM sector posted losses commensurate to the US dollar's gains, but gold's losses were significantly smaller (see chart below).

The same gold outperformance can be seen relative to other commodity sectors, and major financial assets. Gold handily outperformed the energy, base metals and agriculture sectors since the start of the year, but the real surprise is that gold even performed better than the S&P 500. The only financial asset which outperformed gold was US Treasury bonds (see chart below). The gold outperformance may be attributed to the same factors that made bonds the top performer -- global financial markets have hit a turbulent patch. Bonds benefited from the turmoil as the globe's safe haven, and gold also rose up to the occasion. It also helped that the US dollar's uptrend paused, and had in fact weakened. But we do not believe that the weakness of the USD TWI was the source of gold's outperformance - at least, not this time around.

Asian economic survey, credit spread validate the gold outperformance

How do we know that it is not the US dollar effect that primed gold's current strength? We have substantiated the claim by resorting to the ratios of gold over other commodities or over commodity indices. A rational explanation of gold's relative outperformance has to start with the thesis that major movements in the gold over commodity ratios are linked (inversely) with major changes in economic confidence. This is especially so in the case of the current economic crisis in Asia (e.g., China). It is said that in Asia, especially in China, physical gold and platinum are the favored assets during the times when the domestic currency weakens -- that has certainly been the case of the Chinese yuan. The flight to the perceived safety of gold in the eyes of Chinese investors was further boosted by the fall in Chinese equities, which has been partly caused by a mismanaged Yuan devaluation last year (see chart below).

There were reports of super-large withdrawals of physical gold from the Shanghai Gold Exchange vaults since Q2 last year, when the Yuan started to be devalued. And it was not just ordinary Chinese investors which were stockpiling gold. It seems that the high directorates of the Communist Party believe that the international fiat monetary system is unsustainable. The Chinese government has been said to be adding gold to the FX and Gold Reserves on the sly. Whether true or not, the very large importations of gold from Europe with China as destination may have its origin in the Asian and global financial turmoil. Therefore it makes sense that one leading indicator of gold outperformance over the PM sector, and indeed, over the over-all commodity index, is the Ifo's WES Asian Economic Climate Index (see chart below).

The other leading indicator of gold outperformance is the spread between the 10yr Treasury yield and the US corporates' high yield index (see chart above). Credit spreads are one of the leading indicators of degree of economic confidence; widening credit spreads generally signify falling confidence, and vice versa. Therefore, there is a logical, negative correlation between the gold/commodity ratio and credit spreads.

Looking for a bottom in gold

Deteriorating macro factors helped gold outperform since the start of the year. But the outperformance does not indicate whether or not gold has bottomed. The usual route in trying to answer this question is to go to the supply-demand equation. And indeed, gold output has been declining -- which is understandable given the beating down of gold prices in the past five years. Retail investment demand has also been rising since last year, as low prices had sparked a rush for gold coins in the US and for retail gold bullion in China (see chart below). But supply-demand constructs do not pinpoint turning points in the gold's price. Instead we go back to the classic relationship between gold and the US dollar --- stronger US dollar begets weaker gold prices, and a weaker USD boosts the price of gold. In effect, we need to understand when and why the US dollar's valuation is going to change profoundly -- this is what will bring about a significant change in gold's fortunes in the longer term.

Global central banks hold the key to long term demand for gold

One fascinating cue for US dollar long-term performance (as well as gold's) is how and when central banks around the world change the proportion of their assets which are denominated in US dollar relative to their gold holdings. The so-called "dirty float" (the very high percentage of USD denominated assets in central banks' balance sheets) started with the tsunami of petrodollars in the 1970s. However, petrodollars have lost some of their relevance, eespecially after the central banks launched various forms of Quantitative Easing programs. The surfeit of liquidity in global central banks' balance sheets now dominate fixed-income markets, and petrodollars ceased as a major factor in determining long-term interest rates (see chart below).

With the low price of oil, the volume of petrodollars in central bank reserves are also declining. This development may have lasting implications for gold and its price. If those USD dominated reserves fall significantly, it may reopen the way to a global central banks' gold trading program, and to a higher proportion of gold in their reserves. There are strong signs that global central banks are starting to expand their aggregate FX reserves again (see chart below), even as the US dollar TWI begins to manifest a reversal of its recent strong trend, which we discuss further below. A consequent structural US dollar weakness brought about by a shift in central bank balance sheet management strategy should provide long-term positives for gold.

Conclusion: Accumulation of US dollars in central bank balance sheets is nothing more than what any prudent investor would do --- the US dollar's proportion to physical gold ebbs and flows with the strength of the US currency (see chart above). And let us not forget that global central banks are still the biggest holders of gold stocks in the world. What they collectively set out to do will significantly impact the price of gold in terms of degree and in terms of time. In the past few years, gold was de-emphasized as the "dirty float" dominated central bank strategy -- the US dollar reigned supreme, and that stance was rewarded as the US dollar literally obliterated the competition in the aftermath of the Great Financial Crisis (GFC) of 2008. Gold prices benefited greatly during the GFC, but in the post-recovery period, the US economy stood out in better shape relative to the rest of the world (proxied by global GDP). That set up a devastating collapse in the price of gold from late 2011 as economic activity in the RoW was decimated -- a disaster that gold (and commodities) are still trying to recover from. However, there may better prospects for gold in 2016-2017, if global growth climbs out of the 2015 hole it had been to (see chart below).

There are also glimmers of hope for gold coming from global central banks' apparent change of heart regarding the primacy of the US dollar -- we may be seeing a significant USD peak in the making as global FX Reserves prepare to build up again (see the prior chart). In that prior chart, we also see that the rate of change of the USD TWI gains significantly slowed down since Q3 2015, and so by Q2 2016 (after half the base of a yoy comparison), the nominal value of the USD TWI should be peaking. That should be the time the 3yr ROC of the gold price (stripped of the business cycle) starts rising (the longer lag due to the use of a longer base period). We are assuming that the nominal gold price will also bottom in Q2 2016, concurrent with an expected peak of the USD TWI. Those relationships underline the impact of the Global and US FX reserves on the US dollar TWI and Gold prices, and also shed light on the central banks' preference function for gold-over-dollar in their balance sheets.

The US dollar could be significantly weaker in H2 2016

In an earlier Seeking Alpha piece (here), we set forth the thesis that recent improvements in the US Capital Account Balance will likely support a USD rally through to Q2 2016. The US capital account has been strengthening in the back of non-resident capital inflows, a significant portion of which is coming from China, as Chinese investors flee a weakening Yuan being systematically devalued by the government. So we see news of Chinese investors buying prime US real estate and corporations. Chinese corporates have also been paying USD-denominated debts. There is also evidence that illicit flows have increased as well, especially after the Federal Reserve raised rates (see the Cheung, Steinkamp, Westermann paper here). Nonetheless, the capital flight from China may have other less dire explanations -- one those is the legitimate desire of domestic investors and corporations to take advantage of a firmer domestic currency before its exchange rate is pegged lower (see chart below).

Therefore, we suspect that the Yuan devaluation is by no means over, but the process may end by circa Q2 -- there is no redeeming sense for the Chinese government to allow the issue to fester: they are running out of bullets. They might as well as do one big deval (5% to 7%), lift explicit controls on the capital account transactions, and get it over with -- a single, front-loaded infliction of pain which is better than the drip-drip water-cure that the markets have been, and are being, subjected to. There is almost no chance of a large one-off devaluation cum capital control liberalization happening in one fell swoop, of course -- which is unfortunate because the Cheung, Steinkamp, Westermann (CSW) paper suggests that "a more liberal (capital control) regime in China is associated with reduced capital flight." So the odds are that in the interim, capital will continue to fly from China to the US. The CSW paper also comes to that same conclusion, saying that "it will take some time for China to have the free capital mobility that makes illicit capital movement irrelevant . . . Thus, China's illicit capital flow is likely to be around for a while." Those flows should continue to firm up the US capital account balance, and could support the greenback a little longer (see chart below).

However, in the longer term, the climate is less friendly to the US dollar. For one, the US dollar is still severely overvalued, and is now becoming a global problem -- almost everyone wants the greenback to weaken. The overvaluation has certainly become a huge problem for the Federal Reserve, but undercutting the overvalued currency also depends largely on whether or not the Fed realizes it made a policy mistake by raising rates in December. The Fed has further tightened already tight monetary conditions, and if not alleviated soon, it might send the US economy into recession-like conditions in the coming quarters. But parsing recent Fed speakers do not provide the impression that they consider the December hike a mistake, so the Yellen Fed will likely collectively remain stubborn for a while and as a consequence, keep monetary conditions tight and postpone easing financial conditions for some time. This will continue to impart stress on the markets and pose a risk to GDP growth, which would unfortunately keep the US dollar firmer a little longer, as well (see chart below). Collectively, those exogenous and endogenous factors should support the greenback in the short-term at least.

But not too long from now, the Fed could dramatically change the course of the US dollar. Some indications of an emerging "FX Plan B" comes from Mr. Bill Dudley, president of the New York Fed, who said that "recent market ructions have led to considerably tighter financial conditions since December and that any further rise in the dollar could have significant consequences". Mr. Dudley's comments provide hints that the Fed may be having second thoughts about the wisdom of raising rates in a deflationary environment. The offshoot is that the four rate hikes implied by the FOMC SEP dots, may be reduced to two or one, and moreover, a growing consensus suggests a rate hike may not happen at all. Two rate hikes, or one, or none at all -- the US dollar will likely be significantly lower during H2 2016 than it is today.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The company the author represents may have outstanding long or short positions in the commodities discussed in the article. The company may also initiate new positions, long or short, in any of those commodities mentioned, within 72 hours of publication of this article.