The precious metals have been a huge area of interest for us at The RealFinance Newsletter, as well as institutional and individual investors around the world. With the price of gold (GLD) rising 642% from March 2001 to August 2011, investors have been enamored with what seems like a can't-lose investment. However, the fundamental outlook for gold changed drastically starting in September of last year, and not only has it not gotten better, it has deteriorated substantially.
The following chart shows the price of gold over the past 5 years.
As can be seen from the price action, ever since last year's late summer catapulting of gold into bubble territory, then its collapse in September, the precious metals have been a tortured asset class for players looking to go long or short. Prices have been caught in an amazingly well-defined downward triangle for over a year now. While this might seem like technical analysis mumbo-jumbo to many (and indeed much of technical analysis is useless), this phenomenon occurring over the course of a year is very interesting for what it means to investor sentiment.
After September 2011's collapse, gold was only able to rally to a successively lower and lower point before succumbing to renewed selling pressure over the course of the last year. This means that investors were using rallies as opportunities to unload gold, not getting behind a rising trend as they had been for the prior 3 years. The reason why gold has been falling out of favor is the rising value of the dollar.
The following chart shows the Dollar Index over the past year. The Dollar Index is a trade-weighted index of the value of the dollar against a few major currencies.
From August 30th, 2011 to today, the Dollar Index is up nearly 13% and is in a very well-defined up trend. There are a myriad of reasons for the dollar's advance, including the ongoing debt crisis in Europe, the global economic slowdown causing repatriation of funds from emerging markets, and also the comparatively tight monetary policy from the Fed. It is this last factor that we find most compelling in the rise of the dollar's value and loss of appeal of precious metals.
The following chart shows the percentage change in central bank balance sheets since the end of June 2011, the end of QE2. The Fed is shown in white, the ECB in orange, the BOE in purple and the BOJ in green.
As can be seen, the Fed balance sheet has basically been constant for over a year now, while the BOJ, and especially BOE and ECB, have exploded. The BOE has enacted numerous rounds of quantitative easing to breathe life into their economy which continues to be mired in recession due to harsh austerity measures combined with the downdraft wafting in from Europe. The ECB's balance sheet expansion has been one failed measure after another to restore confidence in Europe's banking system through multiple rounds of LTROs and a sovereign debt purchase program that the ECB is about to revive.
Going forward, we see little reason to believe that the status quo is changing. If anything, we believe that the ECB is about to massively expand their balance sheet even further, taking the lead in the global money-printing competition. However, the key ingredient that is missing from a gold rally is the lack of money-printing from the main culprit, the Fed.
At this point, the majority of economists expect the Fed to introduce a new round of quantitative easing at the upcoming September 13th meeting. We believe this is pure folly, as there has been no precursor or foreshadowing of quantitative easing from Chairman Bernanke. As the Fed is a public institution, they are not in the business of surprising markets, and as such, they always telegraph their movements well ahead of time to those careful to read between the lines. Before QE2, Bernanke indicated interest in a new round of asset purchases at his annual Jackson Hole speech, as well as signaling the consideration of such measures in the FOMC minutes months before QE2 was officially announced. Before Operation Twist, a very similar pattern played out, with the FOMC minutes specifically mentioning the FOMC's interest in a stimulative program that did not expand the size of the Fed's balance sheet.
In the most recent FOMC statement, there was no indication that the Fed is moving closer to another round of asset purchases, and in the June meeting's minutes, there was no specific consideration given to any new stimulative measures. While this month's minutes released on August 22nd could strike a different tone, we believe it is highly unlikely. While we are well-aware of numerous FOMC voting and non-voting members' desire to renew quantitative easing, we view this as largely irrelevant. The FOMC is not a democratic council but rather an advisory board set up to inform the chairman of their views. The chairman is under no obligation to take their views into consideration, and we believe Bernanke's views are significantly different from his peers.
While the FOMC is very divided on the issue of new stimulus, Bernanke appears to be firmly on the hawkish side. Over the past year, there have been many more "scary" times that the Fed could have caved to pressure and initiated more easing. On August 9th, after the S&P 500 had fell nearly 20% in the previous 2 weeks, Bernanke only put a date on low interest rate language, and at the following meeting, he initiated Operation Twist, rebuffing the calls of many who craved quantitative easing. In our present scenario with the S&P 500 above 1400 and crude oil and gasoline prices on the rise again, Bernanke has absolutely no motivation to expand quantitative easing. Not only is the fear factor currently absent from financial markets, the economy is doing fine from the Fed's perspective. Employment data is still soft, but non-farm payrolls are growing, and July data has shown a bit of unexpected expansion, albeit accompanied by downward revisions to June's data. From the Fed's point of view, the economy may be stalling but it is not contracting yet. As Bernanke is a very smart individual, he realizes that QE3 may be last arrow left in his quiver, and he will not fire it lightly. We believe Bernanke will only initiate QE3 after it becomes painfully clear that the US is in recession and financial markets have declined accordingly.
Far more likely in September and subsequent FOMC meetings would be an extension of low interest rate language to 2015. As it has been over 6 months since Bernanke last extended low interest rate language in the FOMC statement, we believe Bernanke will pledge to keep rates low for an additional 6 months to 1 year. Indeed, we view such a "soft touch" stimulus necessary as a precursor to more quantitative easing. As we stated above, QE3 may be the last weapon in the Fed's arsenal, and they will attempt to use up any and all intermediate measures before resorting to the nuclear option, QE3.
In addition to the fading attractiveness of gold as an alternative to the US dollar, weakness in other parts of the world are clearly affecting demand for gold. While India and China were considered stalwarts of gold demand with their robust economies and tradition-minded investors who favor hard assets over stocks, both of these economies are becoming increasingly troubled.
India in particular seems unlikely to revive their gold demand any time soon. Shown below is a chart of the Indian rupee over the past 2 years.
As can be seen, the rupee has lost over 26% of its value ove the past year. This is especially bad news for gold investors, as it means that the world's largest demand source for gold has seen its purchasing power reduced by over a quarter. Anecdotal evidence from speaking to gold dealers puts Indian gold demand down 50-60% year-over-year already.
Adding to these problems are the massive growth slowdowns in India and China. Shown below is a chart of India's GDP rate in red and China's in purple.
As can be seen, the slowdown in growth rates in Asia's 2 most important economies has been striking. The loss in purchasing power that a depreciating currency as well as slowing economy has on the average gold consumer in India and China is huge. If precious metals are to move higher, either Asia will need to experience a dramatic turnaround in growth rates, or US investors will need to revive their interest in precious metals in a hurry. Unfortunately, neither seem particularly likely to us over the next six months.
We believe that gold demand has been steadily falling for the past year, and the upcoming FOMC meeting in September could provide the catalyst for gold prices to truly break down. Given the market's optimism about renewed easing, a disappointment on that front could easily be the straw that breaks the camel's back. While gold has shown significant support at the $1525-$1550 level numerous times over the past year, we believe a break below this level could see a quick trade down to $1400, and then eventually $1200 before renewed easing could actually put a bid in prices once again.
Shown below is a chart of the Gold VIX. The Gold VIX measures option prices on the GLD.
As can be seen, the Gold VIX is at an extremely low level. In fact, the Gold VIX has closed below today's level exactly once over the past 4 years. Clearly, gold investors believe that little movement in gold prices will occur over the next few months, and we believe this presents a magnificent contrarian opportunity.
Silver (SLV) implied volatility is showing similar complacency. Shown below is a chart of the implied volatility in the SLV.
As can be seen, SLV implied volatility is at its lowest point ever. Gold and silver investors both are pricing in no movement whatsoever in precious metals prices due to the recent trend of selling volatility.
Specifically, we believe traders should purchase the December gold futures put option for the 1450 strike for $11.30 and the SLV 22.5 December put for $0.63. As volatility in precious metals is at historically low levels, we view the risk/reward scenario in this trade as extremely favorable.
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