Yesterday's action across markets was very interesting, as markets opened higher on the back of decent economic data in the U.S. and Europe. However, precious metals were one of the most interesting trades all day, and we believe there is significantly more action left to occur.
Our longer-time readers will know that as recently as summer 2011, we were staunch precious metals bulls. In fact, we have been bullish gold (GLD) since 2008. However, the parabolic run-up of August and September caused us to reverse our position, and in so doing, we caught quite a bit of the downward move in gold during September's large sell-off by shorting both gold and silver (SLV) futures.
What is scary for gold is that fundamentals for precious metals have become markedly worse, not better, since then. The following chart shows the balance sheets of the four largest central banks in the world. The orange line is the ECB, the purple is the Bank of England, the green is the Bank of Japan and the white is the Fed.
As can be seen, the U.S. has been a virtual bastion of conservatism in central banking for the past nine months. While the ECB was forced to explode its balance sheet by over 50% in a short period in order to contain the European sovereign debt crisis, the Fed has been on hold since the end of QE2 (Operation Twist does not affect the size of the Fed balance sheet). When viewed from this light, it is no wonder why the euro and pound, and more recently the yen, are suffering against the U.S. dollar.
Even more importantly for precious metals traders, this relative strength in the U.S. dollar bodes very poorly for gold as an asset class. If the U.S. dollar performs well against other major currencies, the need to diversify into illiquid, volatile precious metals is much abated. Without expansion of the Fed balance sheet, gold bugs have nothing to hang their hat on. After the creation of trillions of dollars through QE1 and QE2, inflation remains highly subdued. The purchase of gold is simply a psychological flocking to a perceived monetary haven with the worry of lower purchasing power. Without Fed balance sheet expansion, there is not even a psychological threat.
The reason for the lack of inflation despite the massive monetary supply creation of the past few years is clear: The velocity of money in the economy continues to fall. The velocity of money is a measure of how quickly money is moving through the economy, essentially measuring the pace of economic activity. The following chart shows the velocity of money in the U.S. economy since 1980 in white, and the total public debt outstanding in the U.S. in orange.
As can be seen, the velocity of money has fallen steadily since the tech bubble burst in 2000. The only thing that has kept the U.S. economy going is the massive explosion in public debt, taking on new, higher trajectories with the 2000 recession, and then even higher in the 2008 recession.
Gold bugs have bought into gold with the fear/hope of this massive public debt being monetized through inflation. However, the large amount of new money that has been created is not being circulated. Instead, it is staying on bank balance sheets. In this manner, regardless of the size of monetary supply, there can be no inflation without money moving around the financial system more rapidly.
Even worse for inflationists is that for the first time in three decades, the public attitude toward debt in the U.S. has turned negative. Starting with the debt ceiling debate last year and most likely culminating in this year's presidential election, cutting the national debt is now a goal of both political parties. This means that the chances of new fiscal stimulus are essentially zero, and that further massive increases in debt are far more unlikely. Given the massive imbalances in the Japanese, European, and U.K. economies, the U.S. appears in much better relative position to keep fiscal policy conservative relative to the rest of the developed world. For this reason, the U.S. dollar remains in an uptrend, and gold remains flat to bearish.
Also on a more anecdotal note, emerging markets are much less able to buy gold than they once were. While India and China have valued gold as an investment for years as a cultural bias, the per capita incomes in these countries can simply no longer support robust gold purchases, especially if their currencies are outperformed by the U.S. dollar. This phenomenon was witnessed in India when gold purchases actually fell in Q4 2011 (here) despite gold prices also having fallen during the period. The fall in demand was a result of high prices, accentuated by the rupee's fall against the U.S. dollar. While many gold investors would like to believe that emerging markets can keep prices rising indefinitely, they would be much better served by realizing that U.S. hedge funds and investors are ones necessary for him to see positive returns.
The following chart shows the price of gold intraday today.
As can be seen, the FOMC announcement was less than kind to gold prices. This was a move that we foresaw and advised our newsletter subscribers to short both gold and silver coming into today's FOMC statement.
However, today's fall was not all that surprising when taken in the medium term context of gold prices. The following chart shows gold prices over the past year.
As denoted by the red box, gold recently tried to break through stiff resistance at the 1,800 level, only to be flatly rejected and fall over $100/ounce. The fact that gold came within just $10 of breaking through the interim high back in November and then fell such a large amount is telling about just how much overhead supply there is in gold. For those unfamiliar with this concept, it is basically referring to the fact that there were many buyers of gold who paid more than current prices, so that when prices advance, they are eager to sell their holdings and get out. It appears that gold prices are suffering from this phenomenon, at least partially.
Also hurting gold was that it was already in a downtrend coming into today's announcement. Starting with the $100 fall on February 29th, gold's rallies have been capped and it has been making lower lows. To quote a very smart man, Tom Demark is fond of saying that markets never top on bad news and markets never bottom on good news. What this means is that even if markets that are in a down trend rally on good news (i.e. the passage of TARP being bullish for stocks in September 2008), it most likely connotes a mere pause in the sell-off rather than a true trend change.
In the same manner, today's FOMC announcement lacked new quantitative easing, a bearish news item for gold. While no QE3 was largely expected by almost everyone, it still had the effect of causing the U.S. dollar to strengthen and gold prices to fall. As is usually the case in a bear market, bearish news items have an exaggerated effect on the market, and as such, gold prices fell even while equity and risk assets rose.
This leads us to our final, perhaps most powerful point: The way forward for gold prices appears highly bearish regardless of the short-term view on the economy. In our estimation, if stocks continue to rise, the likelihood of QE3 will only become more and more diminished as time passes. This will obviously put pressure on gold prices as they did today.
However, even if stocks fall, gold prices will also likely fall. The following chart shows the total amount of gold held by ETFs.
As can be seen, the amount of gold held by ETFs has skyrocketed in the past five years, going from 20 million ounces in 2007 to almost 80 million ounces today. As such, gold is no longer a fringe investment, but rather one that is held and followed by the masses. The likelihood of gold investors also owning a basket of risk-oriented equities is high, and as such, in a large sell-off, gold prices will also come under pressure. The cross-ownership of gold and risk assets renders gold vulnerable to stock market sell-offs, even though a large enough sell-off could theoretically increase the chances of quantitative easing.
While we believe that more quantitative easing will likely be necessary, we struggle to come up with a scenario in which the Fed will actually embark on such a path unless stocks sell off substantially and the economy weakens verifiably. In such a scenario, gold could easily fall to $1,300/ounce and silver to less than $25/ounce before finding support through renewed quantitative easing.
We continue to recommend shorting both gold and silver, more details for which can be found at realfinancenewsletter.com.
Additional disclosure: I am short gold and silver futures and long puts on GLD and SLV.