Gold, Liquidity And Capital

Includes: GLD
by: Evariste Lefeuvre

Gold prices rebounded on the key support level at $1533, but gold bugs beware: this rebound may be short-lived. Gold is not a reliable safe haven, as the crisis cannot be easily subdued with injections of liquidity (with easing/stimulus measures from the ECB). Of course, gold has proven to be a strong hedge for investors benchmarked in USD, but the link with real rates is broken.

For the last three years, central banks and supra national institutions have tried to solve balance sheet problems (U.S. consumers) and the solvency crisis (eurozone) with liquidity tools (quantitative easing, assets purchases, VLTROs …). This was supportive for gold prices as the excess liquidity was deemed to be inflationary. The chart below shows that gold prices have tracked M2 quite well (I use M2, not monetary base, as M2 has increased even though the money multiplier collapsed).

Investors are becoming more and more aware that the crisis is not about liquidity injection, but about capital increases (Europe) and fiscal spending (CHINA), meaning real money.

Even though the ECB has denied rumors that they had rejected plans to recapitalize a Spanish bank with ECB funds, a solution will not be found in another VLTRO, but through bank recapitalization. There are uncertainties on the capital shortage in Spain, as the housing price adjustment process is not over, but estimates range between 80 and 100 billions euros. The ongoing game of chicken between Rajoy and the ECB may continue, but recapitalizing Spanish banks through bond issuance by the FROB might prove difficult at a time when Spanish government bond spreads are at their highest level since the Euro was instituted. Draghi is clearly in favor of a European program for banks recapitalization.

China has adamantly denied rumors of a massive stimulus that have been circulating this past week. The government intends to implement a more shrewd "stimulus-lite," which means supporting non-residential investment (rural and infrastructure projects) and residential investment (differentiated housing loan policies for first-home buyers), economic structural change from exports/investment economy to domestic demand-driven economy, maintain price stability/market liquidity, and implement the reforms for medium and long-term structural issues (5-year plan). the stimulus package will be much smaller in scale but enough to warrant a soft-lending scenario. As a result there may be limited cuts in Reserve Requirement Ratio, but no lending rate cut, hence a limited boost to liquidity.

Uncertainty on a possible QE3 remains, but in all likelihood any unconventional monetary policy measure would be balance sheet (read: liquidity) neutral. The current level of U.S. Treasury yield should not put pressure on the Fed to act ...

Gold prices may have suffered from the sharp rise in the USD but one reason for gold's weakness lies in the limited potential for a widespread use of liquidity-enhancing economic policy tools. The focus on recapitalization and stimulus is much less bullish for gold than the liquidity injections carried out over the last few years.

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