Greenback Über Alles

From the September 15, 2014 HRA Journal: Issue 220

Ok, maybe there is something to be said for paint drying.   The market got less boring as we moved into September but not in a good way.  The US Dollar’s ascension clobbered just about everything else including commodity prices in general and gold prices in particular.  

We’re coming up on another Fed meeting and a Scottish referendum. We could see more volatility ahead.  I think the Scots will vote to stay within the UK.  That could give both the Pound and gold prices a boost.  The Fed meeting is a tougher call.  Traders are convinced the start of rate increases will be moved up. That, combined with weak growth numbers from overseas is making traders in New York nervous.  I think Yellen doesn’t want to accelerate things for reasons detailed below but even a slight change in wording could have a big impact right now. 

Gold prices have been pushed below their May lows and bears are targeting last year’s low now.  That doesn’t mean they will get their wish.  Bullion is very oversold and the Dollar is equally overbought. The chances of a bounce in the gold price should not be discounted, especially if the Fed meeting and referendum go the way I think they will. 

Gold stocks have been trading better than bullion which tells me I’m not alone in expecting a bounce.  We need to see bullion get back towards and preferably above $1300 to revive trader’s spirits.

Anyone wondering about gold’s (and oil’s, and copper’s and…) recent pummeling need look no further than the chart below.  The US Dollar went hyperbolic and is currently hanging onto those gains.  There are plenty of reasons for it though the most important ones lie on the other side of the Atlantic.

As I always point out, there is no such thing as a one sided currency trade.  If you’re buying a currency then by definition you’re selling another and vice versa.  Sometimes the “currency” on the other side of the trade is a financial asset that simply has strong inverse correlation to the currency being traded.   In the case of the US Dollar both Euro and Yen are obvious choices (especially the former) but US denominated commodities (gold, oil or copper) are also used sometimes depending on the trade being built and its rationale.

In the case of this rally the main victim is the Euro, and well-earned victimhood it is too. After dithering for years the ECB finally pulled the trigger.  Draghi has promised a Euro version of QE and unexpectedly cut some deposit rates, effectively bringing them into negative territory.

News of impending QE and continued weak economic readings had a predictable impact on the Euro.   Already trading badly, the Euro was clobbered again, dropping below $1.30 US for the first time in a year.  It’s now sitting just above the support level it bounced off of a couple of times last year.  Few market observers expect that level to hold this time.

There are no real details on the QE program in Europe.  I have noted before that I think it will be tough to execute and my views haven’t changed.

Unlike the US Fed the ECB is not dealing with a monolithic bond market.  It has to enter specific country markets to buy securities which means the composition of the buying will be an inherently political decision.

There are countries, notably Germany, that are still opposed to the idea of QE and may disallow the ECB from buying in their markets.  The EU has a well-earned reputation for being glacially slow to make even the smallest decisions.   I don’t think a QE program will be any different so I’m not holding my breath.  Execution will probably be slow and Draghi may get pushback from some member governments that reduces his choices when it comes to which bonds to buy. I don’t think QE is a horrible idea even though I’m not convinced it will work.  Tightening the ECB balance sheet when everyone but the Bundesbank could see how close the EU was to entering a deflationary spiral was craziness, even if you hate the idea of QE.   Like addiction, the first step is admitting the problem.

The other currency getting sold and helping to fuel the run in the USD is the British Pound, thanks to a scare on the upcoming Scottish independence referendum.   After trailing in the polls for months the “yes” camp came out ahead in a couple of opinion polls.  This freaked out the Brits and the currency markets.   I think its important to note that the polls are by no means unanimous.   There are still more polls showing the “no” side with a slight edge.

I know little or nothing about the specifics of the arguments on both sides of this issue.  I can see that the “yes” side seems to be vaguer about the details.   I claim no special insights into the Scots character, notwithstanding being half Scot by heritage but I have seen this movie before.

I lived through a couple of Quebec independence referendums.  I find the media coverage is eerily similar.  The yes side is light on specifics and appeals to Scots identity while assuring everyone all the tough stuff will be figured out after the vote to their benefit.  The no side is more analytical and assures Scots that it’s a two sided negotiation and that they won’t get their way on many, probably most, items.

I saw exactly the same approach during two Quebec referendums.  Both of the Quebec votes were near things but in both cases the final tally for separation was lower than expected a few days before the vote.  I think when Quebecers stepped into the voting booth and thought about how much was unknown they went with the status quo.

I expect the same outcome in Scotland.  I could look foolish in a few days but I think the “No” side will win.  That hasn’t been completely priced in.   That outcome should be positive for the Pound and negative for the US Dollar (if only because it’s the other side of a long Pound trade) and therefore should be gold positive too.

The other “big” decision this coming week is the latest US Federal Reserve meeting, announcement and press confab.   There has been a clear shift in the past couple of weeks by traders when it comes to the timing of US rate increases.  Good retail sales and ISM numbers and a shrugged off weaker August payroll number has traders thinking rate increases will start this year or at least very early in 2015.

The TNX (10 year yield index) above shows the move up in yields in the past couple of weeks.  It’s hardly a stampede out of 10 year treasuries but is the biggest short term upward move in some time.  There are clearly more traders buying in.

There is no doubt the pressure is increasing on Yellen.  This is another factor weighing on the gold price, and other commodity prices for that matter.  Maybe Yellen buckles under the pressure this time and changes the wording to something more hawkish.  If that happens it would be another positive for the $US and a negative for gold, though some of the move is already priced in.

I’m not sold on the idea that Yellen toughens the wording quite yet and definitely not sold on the idea of the first rate increase happening this year.   My reasons can be seen in the table below that I reproduced from the New York Times.

The table nicely sums up some of Yellen’s concerns about the US labour market.  It shows the percentage change in median pretax income since the Great Recession for different sectors of the US economy, adjusted for inflation.  The bottom line is that the only groups that have seen income gains are the top 20% of households by income and those with a college degree and the second group gained by a bare 1%.  When all families are counted as a single cohort incomes decreased by 4.7% and the tally for young families and particularly seniors is even worse.

This is yet another version of the rich getting richer story. The top 20% of households are those with money to spare for investments that are capturing some of the gains of Wall St.   For the vast majority that depend on earned income alone the story hasn’t been positive.  The worst off are seniors though I think that has much to do with the zero interest rate policy.  Once rates rise many seniors will see better yields on fixed income portfolios—I hope.

Even through the unemployment rate has dropped only a small minority of households are taking more money home on a real basis.   Consumer spending has increased but some of that has to be debt driven based on the table above.   A low savings rate and low interest rates have “helped” that but it’s no long term solution.

The pattern displayed by that chart will not allow for long term growth in consumer spending at higher levels.  We’re going to hit a wall on consumer spending unless everyone just ups their borrowing to accomplish it.   We know how that ends.

That is Yellen’s conundrum and the reason she’s been slow it increase rates.  She can’t hold off forever.  Things have to normalize at some point but Yellen knows that income losses give her little room to maneuver and less room for error. I expect her to continue to take things slow.

If I’m right about that it will at least a mild positive for gold and other commodities.  Slowing growth just about everywhere, especially China, may cap gains on pro-cyclical commodities like base metals and oil.  It shouldn’t have the same impact on gold.

I think physical demand will help underpin the price as we move into Q4, the strongest buying season of the year.  How that gets presented in the media will be a tougher question.   Some percentage of buying in India will be through “unofficial channels”.  It won’t get counted.  More and more of the gold being imported into China will go through ports other than Hong Kong.  Again, that means it won’t get counted.

There have been lots of headlines about demand “collapsing” in China.   I don’t know the true current demand figure or China and I don’t think the authors of the articles about collapsing demand know either.  They are just parroting official numbers out of Mumbai and Hong Kong and dividing by last year’s number.   That method won’t work anymore.  Be very suspicious about articles that claim physical demand is collapsing.  I think it’s down but not by a lot and I think continued physical buying will be more supportive than the mainstream press expects.

That doesn’t solve the optics problem but if physical demand is good in Q4 the support it gives prices will speak for itself.  Hopefully some new metrics evolve that will give a good objective reading of Asian demand.

Gold producers have performed better than bullion during this pullback. As the chart above shows the GDX is still well above its level in May when gold was trading $10 higher.  Traders on the gold equity side don’t appear convinced that we are heading to or near the 2013 low.  If current levels hold it should be a confidence boost for traders even if gold doesn’t zoom higher.

There have been a couple of recent takeovers in the development space, and a couple of receiverships.  Both are positives.  Takeovers generate fresh cash in the sector and mine closures winnow the sector down to stronger players. We need more of both, with some new discoveries thrown in to keep the process going.

Eric Coffin was recently interviewed by the Gold Report. To read the HRA featured interview titled “Can Investors Still Find Tenbaggers?” please click here

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