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Cliff Wachtel
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Cliff Wachtel, CPA, is currently the Director of Market Research, New Media and Training for Caesartrade.com, a fast growing forex and CFD broker. He covers a variety of topics including global market drivers, forex, currency hedged and diversified income investing, and is currently working on a... More
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  • Why Gold’s Sudden Move? The Greatest Confidence Game Unraveling? 0 comments
    Sep 9, 2009 10:27 AM | about stocks: UUP, UDN, FXA, FXB, FXC, FXD, FXE, FXEN, FXY, JYF, AUNZ, CYB, GLD, CNY, USO, DUG, DBV, SLV, OIL, ERF, CEL, ORAN, PBA, BPL, EPB, EPD, ETP, KMP, MMP, NS, SXL, TPP

    For those who don’t follow at least the big picture of currencies and commodities, here’s something you should read, because you may see that you need to start paying a bit more attention. The US dollars status as reserve currency, though safe in the near term despite the hype otherwise, is ultimately based on confidence, as is the case with any fiat money.

     

    The Biggest Unanswered Question This Past Week: What is the Real Reason for Gold’s Sudden Move?

     

    Chronicle of a Mystery: September’s Unexplained Events

     

    Tuesday, September 1st

     Markets drop around 2% on high volume, on fears that global stock markets are overpriced and due for pullback during September, historically a losing month for stocks, especially after they’ve risen since March and continue to do so in July and August despite generally declining revenues, earnings, and very mixed news.

     

    Wednesday, September 2nd

    A very odd thing happened: potentially very bad news came out. Predictably, stocks dropped again. Shockingly, gold shot up.

     

    The bad news was the ADP non farms payroll indicated worsening unemployment for the US. Because consumer spending is about 70% of US GDP, and the US remains the world’s largest economy, that is very bad news for US and global recovery hopes. Worse still, the ADP report is a leading indicator of the official US government non farms payroll report that would come out 2 days later on Friday. This was a blow to the weakest link of the recovery.

     

    Yet gold rallied hard, up about 5% from September 2nd-3rd. It has since slowed, but neither pulled back nor stopped rising. It didn’t make sense.

     

    How Gold Behaves

    Since the crisis began in the summer of 2007, gold has generally gone up with good economic news, and dropped with bad news, since recovery implied inflation, and gold is considered the ultimate inflation hedge. Bad news decreased the chances of inflation, so gold was supposed to drop. Yes, Armageddon-end-of-currency bad news might support gold, but the ADP report was hardly that bad.

     

    The Financial Media Baffled

    Financial writers are paid to explain the markets, so they tried. Common reasons given, however, didn’t make sense. Like clergy and psychiatrists, financial writers are often called upon to explain that which is often ultimately unknowable by mortal means, yet have rewarding, respectable career to preserve.

     

    So the pundits gave it their best shot. Common reasons given, however, didn’t make sense. They included: They included:

     

    A weakening dollar

    Gold and other commodities are priced in dollars, so it makes sense that they would rise as the dollar falls and visa versa. However, the USD and gold have been moving in opposite directions for years. The USD didn’t make any huge moves down when gold took off. This reason explains neither the timing nor magnitude of the move.

     

    Concerns About Recovery and Inflation

    Huh? This is a contradiction in terms. Less recovery generally means less inflation, not more, because people don’t spend. It’s usually one or the other, but not both (except for rare cases like the ‘70s stagflation, which was due mostly to a rare quadrupling of the price of an external  - oil -  that both raised prices and killed the economy).Again, except for end-of-world/currency bad news, gold falls with bad economic news, so recovery worries suggest less inflation or even deflation.  In recent years, that has caused the USD and other safe haven currencies to rise, and gold to fall.

     

    A “technical” move

    A non-explanation. This is what those of us in the analysis business commonly say when we don’t know. Those familiar with technical analysis know that it is a useful tool, but successfully applying it is a much art as science, and there is wide variation as to how it is applied. Was key resistance broken?  Key support held? A series of indicators triggered in the bowels of institutional supercomputers? Who knows? Momentum driven trading explains how the move continues, but it doesn’t explain the timing or extent of the move.

     

    So How Do We Interpret Gold’s Behavior?

    So here are some reasonable speculations.

    Background: Why the Ballooning Money Supply & Fear of Inflation

     

    Those familiar with the story of the USD’s travails over the past 2 years can skip this part. Those who aren’t, shouldn’t.

     

    Since the current economic crisis began, the supply of every major currency, including the safe haven USD and JPY, has seen unprecedented increase in supply as governments were forced to pump cash into suddenly depleted banking systems and economies to keep banks alive and economies liquid and functioning, as the subprime lending crisis cast doubt on the value of trillions in financial sector assets.

     

    Governments had little choice. If they didn’t, they faced the immediate certainty of another Great Depression from a domino effect as disappearing banks, credit, business, employment and consumer spending slammed each other down into an accelerating tailspin/death spiral/other dramatic metaphor.

     

    So governments bailed out banks, and spent on stimulus programs with new cash, paper or electronic. They bought time to fix things and restore confidence. As long as the world remained in depr-err-recession, money supplies could bloat out while scared businesses and consumers would lock down spending until better times arrived.

     

    The problem was that when they did, there was a strong chance that the unprecedentedly large reservoirs of currency would flood into economies and chase a recession- depleted supply of goods, possibly causing unprecedented inflation, aka hyperinflation. Central bankers assure us they have the tools to prevent this. What a relief.

     

    Seriously, though, that threat was somewhere in the future. Meanwhile, hard times would create enough deflationary pressure to keep the floodgates shut.

     

    For the USD, the future problem was compounded because there were already vast oceans of accumulated dollars sitting overseas with every foreign export economy that had diligently saved its export-earned dollars over the years. These nations held dollars because they had confidence in the USD’s value. The massive stimulus spending and its inflationary potential now shook that confidence.

     

     

    The Biggest Too-Big-To-Fail: America and the USD

     

     

    Even as they saw the US gutting the dollar, and the value of their currency reserves, the exporters’ knew their options were limited. The US dollar and economy remains, for now, the ultimate too-big-to-fail. If the exporters sell the USD, or even complain too loudly, they'll drive down the value of their own currency reserves, and possibly cripple the US, one of their biggest, irreplaceable customers (and in many cases, military protector of last resort). Besides, replacing a reserve currency isn't easy, and can't be done quickly. They knew this, and so did Washington.

     

    The romance was over, but divorce was just too expensive.

     

    So the exporters spent this past year alternately whining about the dollar and supporting it, threatening to replace it, while continuing to buy US bonds and affirming the dollar's reserve currency status and maintain confidence in the USD. As long as worldwide recession restrained spending and even threatened inflation, then the inflation threat was somewhere in the future

     

    Thus the USD is part of a very big confidence game in which many have a huge stake, whether they like it or not.

     

    Recently, however, with some signs of actual bottoming, that future may be getting closer. Now what?  Has this become a different kind of “confidence” game, with the exporting economies as the victims? Not if they can help it.

     

    They couldn't just dump the dollars into the currency markets – so they decided to start buying hard assets of all kinds. This is why commodities of all kinds have entered a long term bull market.

     

    Gold is particularly in demand when there is fear of inflation or other threats to the value of currency, so it is clearly on menu for many.

     

    As noted above, because swollen global money supplies are very likely to mean inflation once recovery comes, , gold has generally gone up along with stocks on signs of economic recovery, because it threatens to bring inflation.

     

    Our Analysis & ConclusionA No Confidence Vote in Safe-Haven Currencies (JPY, USD, and CHF)

     

    With most expecting a weak recovery over the coming year, stocks or industrial commodities like crude oil or copper may not be the place to park a larger portion of their wealth than they already have. Many of the leading exporters like China and the oil exporters are already diversified into industrial commodities. What choice do they have? Currencies or precious metals.

     

    They appear to be choosing the metals. They are not choosing the usual safe haven currencies: the JPY, USD, and CHF.

    In short, the move in gold is at least a tentative no-confidence vote in currencies as a safe haven store of value.

    Who is buying? Not clear at this time. That fact by itself suggests exporter central bank or sovereign wealth funds, which often prefer to act through intermediaries for fear of moving markets against themselves because of their sheer size.

     

    Admittedly, this doesn't explain the timing of gold's move. Thus I revert to my analyst's habit and assert that the move indeed began as a set of technical criteria were triggered, prompting a rise that set off other more momentum driven automated trading programs, which set off others, etc.

     

    Obviously, the full diversification plan to work, however,  the Asians, oil exporters, and other big dollar holders need to make sure the USD doesn't crash, both to preserve the value of their own dollar holdings and also keep a very valued customer and unpaid protector of  various borders  and oil routes.

     

    S don't panic. They must do this slowly enough to avoid a run on the dollar and the value of their own holdings. This diversification will continue to include other kinds of hard assets too, like industrial commodities and their producers, US real estate, etc.

     

    Thus don't be surprised by coming statements of support for the USD and some kind of rally in the near term. The long term trend for the USD may be down, but expect to see rebounds, even sustained rallies.

     

    In the longer term, gold remains well supported by

    • fears of inflation, if recovery continues
    • fears of currency collapse, if recovery fails
    • continued drive by exporting nations and businesses to reduce the proportion of their USD holdings

     

    So, What Do You Do?

     

     

    Currency traders: Long term bias to commodity currencies: long AUD, NZD, CAD, and EUR as a USD hedge, since the EUR tends to move opposite the USD. Short term, beware likelihood of pullback and use it as a buying opportunity.

     

    Those preferring ETFs can consider:

    RydexShares ETFs: Australian Dollar (NYSEARCA:FXA), Canadian Dollar (NYSEARCA:FXC), Euro (NYSEARCA:FXE), Swedish Krona (NYSEARCA:FXS)

    Wisdom Tree ETFs: New Zealand Dollar BNZ

    PowerShares ETFs: Group of 10 Carry Trade (NYSEARCA:DBV), and U.S. Dollar Bearish (NYSEARCA:UDN)

     

    However, be ready to go long on the USD when it rallies, a real likelihood when equities pull in since the USD still is in demand in times of fear as a safe-haven, along with the JPY and CHF.

     

     

    Commodity Traders: Long term bias to precious metals. Short term, after a move like we've just seen, be ready for a retest with stop loss orders if you go continue to go long.

     

    Stock Traders: Neutral in short term, though we believe there is more to be made playing the downside, from the upper end of multi-month trading ranges.

     

    Income investors: Limit new positions to money not needed in the near term and stick to the commodity or essential service provider stocks we’ve recommended over the past months that pay you in currencies other than US or at least earn in other currencies. We have yet to find a good precious metals income play. Recent suggestions include:

     

    Communications

    Cellcom Israel Ltd. (NYSE:CEL), France Telecom (FTE) Telefonica (NYSE:TEF)

     

    Canadian Oil/Gas Energy Income Trusts

    ARC Energy Trust (OTC: AETUF, TSX: AET-UN), Claymore/SWM Canadian Energy Income Fund (NYSEARCA:ENY), Enerplus Resources Fund (NYSE:ERF), Peyto Energy Trust (OTC: PEYUF, TSX: PEY.UN), Provident Energy Trust (PVX, TSX: PVE.UN), Vermillion Energy Trust (OTC: VETMF, TSX: VET.UN)

     

    Canadian Energy Infrastructure Income Funds

    Altagas Income Trust (OTC: ATGFF, TSX: ALA.UN), Pembina Pipeline Fund (OTC: PMBIF, TSX: PIF.UN)

     

    Canadian Utility Income Trusts

    Atlantic Power Corporation (OTC: ATPWF, TSX: ATP.UN) and some very positive clarification from their CFO Mr. Patrick Welch, Bell Aliant (OTC: BLIAF, TSX: BA.UN)

     

    Canadian Health Care Income Trust

    CML Healthcare Inc. Fund (OTC: CMHIF, TSX: CLC.UN)

     

    Canadian Real Estate Income Trusts

    Canadian Apartment Properties REIT (OTC: CDPYF, TSX: CAR.UN), Northern Property REIT (OTC: NPRUF, TSX: NPR.UN), RIOCAN REIT: (OTC: RIOCF, TSX: REI.UN

     

    US Energy Infrastructure Master Limited Partnerships (MLPs)

    Buckeye Partners (NYSE:BPL), El Paso Pipeline Partners (NYSE:EPB), Enterprise Products Partners (NYSE:EPD), Energy Transfer Partners (NYSE:ETP), Kinder Morgan Energy Partners (NYSE:KMP), Magellan Midstream Partners (NYSE:MMP), Nustar Energy (NYSE:NS), ONEOK Partners (NYSE:OKS), Sunoco Logistics Partners (NYSE:SXL), TEPPCO Partners (TPP), Tortoise Energy Infrastructure Partners (NYSE:TYG)

    Coal MLPs

    Alliance Resource Partners (NASDAQ:ARLP), Northern Resource Partners (NYSE:NRP), Penn Virginia Resources Partners (NYSE:PVR)

    Other MLPs

    Terra Nitrogen Company, L.P. (NYSE:TNH), StoneMor Partners (NYSE:STON)

     

     

    Disclaimer & Disclosure: the opinions expressed are not necessarily those of AVA FX. The author holds positions in the above instruments.

     

     

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