Simple Game Theory On GLD - Based On Soccer, Global Inflation And QE Expectations

Aug.13.12 | About: SPDR Gold (GLD)

When I was younger and there were not enough people to play a game of small-goal football (soccer), the four or five of us would create a small circle and play a game of "Raise". For those of us who don't know, the objectives of Raise are to keep the football in the circle and to keep it bouncing. If you made the football either stop bouncing or exit the circle, you were knocked out and further penalized by doing 5-10 push ups (dependent on the risk tolerance of my friends in the circle). To say the least, the game got pretty intense, as none of us wanted to be disqualified, nor do push ups.

When I observe the price movement in the SPDR Gold ETF Trust (NYSEARCA:GLD), I notice investors playing a game of "Raise". They are huddled around in a circle, using their skills of inflation and QE, trying to keep the price of gold firm or "bouncing"; however, for those of us familiar with this game, eventually the ball (GLD) will either run out of the circle or stop bouncing, disqualifying players from the game.

Keep the Ball Bouncing

GLD can be construed as an asset that investors utilize to protect themselves from an inflationary environment and depreciation in their portfolio of different currencies. For the "Raise" game in gold to continue, the world, particularly the developed economies, should be facing inflationary pressures. However, based on data from the IMF, inflation expectations remain tepid for 2012. Core inflation, which excludes volatile components such as food and energy is also expected to remain stable. The chart below shows the IMF's inflation forecasts for Emerging and Advanced economies. After making a marginal increase for the beginning of 2012, inflation trends downwards, remaining above 2%.

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So with inflation expectations at these low levels, another concept that maintains GLD's bounce is that of Quantitative Easing (QE). Borrowing from the Bank of England's Quarterly Bulletin 2011 Q3, one of the results of QE is to boost asset prices, which may include, but not limited to, the price of GLD. The flow chart below explains the effects of QE, particularly from the Bank of England. Recently the Bank of England increased its QE program with a further £50bn to bring total asset purchases to £375 bn.

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Source: The United Kingdom's quantitative easing policy, design, operation and impact.

According to Bank of America economists, there is an 80% chance of another round of quantitative easing by the Federal Reserve, affectionately known to most as QE3. The speculation of another round of QE by the Federal Reserve has been rampant across all media, which may have prompted investors to purchase assets which the FED will likely buy, such as US Treasuries. Using the ETF IEF (iShares Barclays 7-10 Year Treasury Fund) as an example, investors may have taken positions in this security in anticipation of QE3. As at August 10th, 2012, IEF has produced a total return of 3.45%.

Rolling Ball/Out of the Circle

In a recent media appearance, the Dallas Fed President, Richard Fisher, was quoted as saying "adequate stimulus is in place" and "we're at risk of overburdening the central banks." While growth has been sub-trend, and unemployment remains elevated, the conditions in the U.S. are not enough for the FED to implement another round of QE. US jobless claims remain in an overall decline and US GDP positively staggers along. These perceptions were partially based on the charts below.

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The anticipation on the other side of the pond is similar. The existing QE package, along with the current Bank of England's (NYSE:BOE) bank rate should maintain the BoE's mandate of monetary stability. Monetary stability is a two pronged approach of keeping inflation low and stable. The BoE thinks that inflation is likely to remain at or below its 2% CPI target over the next several months. The chart below highlights the BoE's expectations, with the highest probability of CPI around 2%. Gold may soon roll or be sent out of the circle as inflation and QE expectations ease.

Source: Bank of England Inflation Report August 2012.

Technically Speaking

The real eye-catcher is the price movement of GLD over the past 12 months. GLD was thrown into the air, making a high of US$185.86 on September 5th, 2011. It then proceeded to bounce on the pitch, around the US$148 price level, on December 26th 2011 and May 28th 2012. GLD was unable to attain the highs that it made in September 2011 and expectations are for it to descend below the US$148.42 price level in the near future, thus ending the game of "Raise". Markets technicians attribute the setup in GLD as a Descending Triangle, seen in the Weekly chart of GLD below.

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How to Avoid Push-Ups

In light of tepid global inflation and limited expectations of QE, the USD dollar may quietly increase in value versus other global currencies for the remainder of 2012. One way for investors to avoid 'push-ups' and win the game is take a short position on GLD. Another is through the ETF UUP. UUP is the Powershares DB US Dollar Index Bullish Fund. The Fund is designed to replicate being long the US Dollar against the following currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and the Swiss Franc.

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

Disclaimer: The views expressed in this article are my own and is not necessarily the views of any companies or organizations I am affiliated. I expressly disclaim all liability in respect to actions taken based on any or all of the information in this writing.