Trade Desk Client Note
Global Futures Review
Gold: Buy The Dip? Or Bye Bye Dip?
As the price of gold has pulled back from its run up to $1,900 and silver continues to hold support and test near-term highs, investors are left to ponder what exactly drives the movement of such an important and financially sensitive commodity, and how bullion trade impacts the mid-term outlook for the US dollar.
Net/Net of the story below is that there could be a long way for gold and silver bullion to go before fair value can truly be said to have been found. It will not be a case of blinding buying all that shines, but for those with patience who plan out a strategy to buy the dips, there is a lot to be said for diversification into bullion and futures contracts.
The signals to clients have been issued since gold was trading around 950 an ounce, then issued again at 1100, 1250, 1390, 1470, 1525, 1590, 1625, and most recently at 1675. All came with near-term and mid-term targets that covered all outlooks as the buy-the-dip pattern of trade held steady.
Gold has once again pulled back, this time to the 1520 area as expected, and is now being monitored for signals that momentum, sentiment, and price action are strong enough to buy the dip for a long-term move. Most people are aware that gold prices respond to inflation expectations and that central banks, as the largest holders of gold, are big players in the market. But there is not always clarity in understanding as to why and how these players affect prices, and what their ultimate goal may be.
Although few people actually know how central bankers from Bombay, Berlin and Beijing look to manage the global gold market, a better understanding of how our current system came to be provides some clue about gold's recent behavior. The First World War was not only catastrophic to an entire generation of Europeans, but it also left the international financial system in tatters.
After the war, the great powers met in Rome to re-establish a workable international financial system. The British pound sterling, which had been fully convertible into gold, was selected as the official 'reserve currency.'
During the Great Crash of the 1930's, the collapse of Austrian and German banks triggered a run on sterling for conversion into gold. Unable to withstand the assault, sterling was replaced as the reserve by the U.S. dollar. Although the dollar was also convertible into gold, the Roosevelt administration had limited the risk to the U.S. Treasury by restricting redemption only to central banks.
In 1944, the newly established International Monetary Fund (NYSE:IMF) selected the U.S dollar as its 'international reserve asset', which enshrined a quasi-gold standard to undergird global financial transactions. However, the inflationary policies of most governments caused the market gold price to rise above the official price of $35 an ounce.
In 1961, as the price of gold drifted higher relative to the dollar, the major central banks formed the London Gold Pool, a 'gentleman's club' to coordinate gold sales in order to stabilize gold prices. But by 1971, the dollar's devaluation had overwhelmed their coordinated interventions.
Ultimately, President Nixon was compelled to break the dollar's last links to gold by closing the 'gold window' to other central banks. For the first time in fiscal history, the world monetary system 'floated'.
Since then, major central banks have continued to debase their currencies at pace with the U.S. dollar. In 1978, via the IMF, there was a move to demonetize gold, which stood to expose the true rate of consumer inflation. This was first carried out by massive central bank sales of gold in exchange for Special Drawing Rights (SDR's) from the IMF.
When this failed, the U.S. gained support, in 1999, for the Central Bank Gold Agreement (CBGA) to coordinate the release of central bank gold into the market.
Officially, at least, this was meant to prevent central banks from dumping gold. However, it is highly suspicious that these nominally independent central banks would take coordinated action to support the gold price. This is especially true given that they've spent the last forty years trying to do the opposite. It is likely that the CBGA was designed to covertly time purchases and sales to magnify gold's price volatility, in order to dissuade investors from holding it over the long term.
This intervention was probably the biggest factor in distorting the gold market, but the precious metals investor should understand that central banks can only pressure the market, not dictate it. Gold will continue to move higher as the following dynamics unravel.
First, the dollar has benefited from its reserve status, which creates demand for dollars to complete various transactions. However, the conditions that put the dollar on the world monetary throne have already changed, and it's just a matter of time before it is forced to abdicate. Just as French endured as the international diplomatic language long after France waned as a world power, so too is the dollar coasting upon its former glory.
When the dollar loses its reserve status, overseas demand for the greenback will decline and a reserve of a mix of bullion, rare earth, and precious metals will likely flourish. The fact that US government Bonds now are slightly tainted by a downgraded credit rating only strengthens the gold holder's hand in the long run.
Second, many holders of surplus currency have diversified into the euro. But the euro is a tower built on a potentially unlevel ground. Already it is showing cracks as Greece, Ireland, Spain, and Portugal exhibit signs of economic failure, along with a banking sector that although strong is now susceptible to new balance sheet standards criteria being implemented.
If the solvent states of the union succumb to pressure to bail out their weaker neighbors, the euro will lose a part of its newfound credibility in the global arena.
Third, the U.S government and Federal Reserve have been successful in distorting the official inflation figures, and at times attempting to portray the message that inflation is not actually going to impact the consumer for too long. Fortunately for the Feds, people tend to think in 'nominal' rather than 'real' value terms. For example, investors still feel good buying stocks and bonds of American companies in U.S. dollars.
They don't realize that when measured in terms of gold, or money unimpeded by fractional banking standards, the S&P has lost some 20 percent over the past ten years.
Fourth, and perhaps least understood, the massive inflation numbers already created by the Federal Reserve remains hidden within the banking system. As long as banks are able to lend directly to the Fed and Treasury at no risk, they have no incentive to circulate their new dollars. Only when bankers leverage up and lend to industry, or have their hands forced to do so, as happened in 2004-2005, will the prices of consumer goods skyrocket, and reveal the already massive shadow-inflationary pressures.
Finally, by changing accounting standards for the banks' toxic assets and making self-congratulatory pronouncements, the government has created the impression that the crisis has been averted and that faith has been restored in paper currencies. This feeling of relief is flawed fundamentally.
It will not be long before investors are brought to the devastating realization that a true recovery from a credit boom requires tightening and recession - that Washington did not avert catastrophe, but ensured it, and that the economic expansion that is being called for may still be a long way off.
As these dynamics unravel, the full consequences of U.S. profligacy are being felt around the world, as inflationary pressure builds in-line with higher commodity prices, due in part to the synthetic weakness created in the dollar. Central bankers could sign any agreement they wish but it won't stem the meteoric rise of gold. By then, investors will understand that those left holding dollars will be left holding the bill in the long run.
Signals, market updates, trade plans, and reviews will be sent directly to clients as history is written in regard to gold bullion valuations.