We're Number Two!: The Year Ahead - Part Two
From the January 15, 2015 HRA Journal: Issue 226
The first couple of weeks of 2015 certainly look nothing like the same period in 2014. It would be wise to treat that as a warning. We will all have to stay on our toes this year. The many imbalances in the world’s financial system are coming to a head. All may be resolved in a positive way but there are many places things can potentially go wrong.
The copper flash crash and the Swiss unpegging their currency from the euro are but two examples of the high volatility world we’re in and that was all just this week. Next week brings the ECB meeting that may or may not kick off QE. Either way we could see more wild swings in currencies and metals. I’m quite pleased with how gold is trading but expect the unexpected around the time of the ECB meeting then the Greek election.
I’ve laid out my reasons for why gold has strengthened and why it should have room to strengthen more. It seems less and less likely most parts of the world will be able to dodge deflation. That is not always bad for gold for reasons discussed in this issue and, in any case, there is certainly some “risk off” buying across a number of markets.
The third issue dealing with other metals will be out close to month end.
Here’s hoping Draghi manages not to disappoint everyone.
As we entered 2015 the dominant trends of 2014 continued. The US continued to print (relatively) better economic readings. Deflationary forces continued to strengthen leading to falling sovereign bond yields and weakening inflation readings. Just about every market strategist is calling for a near term bounce in the oil price but it’s still weakening too. The US Dollar continues to strengthen which of course is adding weight to some of the downtrends mentioned above it.
I commented on both oil and the Euro in the last issue. Two items I focused on—the ECB meeting and Greek election—are dead ahead. We got a preview of the potential turmoil When the Swiss National Bank shocked markets by dropping the Euro peg. You’ll recall I wrote in November about how untenable the SNB’s position was. Its troubles would have been magnified if the ECB goes through with QE. It decided to cut its losses now.
Intentional leaks indicate Mario Draghi is working on selling a €500 billion QE program. Will that be enough? Europeans have lost confidence and I don’t know if something as indirect as a QE program changes that. It may be that nothing but time (and a lot of intervening bankruptcies) will accomplish anything.
I hope to be proved wrong but I’m not convinced a half trillion Euro program will move the needle. Adding that to the ECB balance sheet only recaptures half the shrinkage it’s suffered in the past two years so it’s not that impressive.
The Greek election is still too close to call. Syriza is leading but most polls are effectively a dead heat. We may see a repeat of 2011 with a second election forced if a coalition large enough to govern can’t be built. A second election would come after the next refinancing deadline for Greece. That could get interesting. As noted last issue, Greece doesn’t have the leverage to scare the EU the way it did in 2011. The election results may have less impact than the fear of them, outside of Greece at least.
The three year chart above for the US Dollar Index is a sight to behold. The 25 year monthly chart below it gives some needed perspective but the recent surge still looks impressive. The long term chart shows it’s near the center of its long term range but the upper part of its comfort zone. It also reinforces just how steep the current move is.
The $USD is overbought by technical standards but with so many high impact events coming I don’t think that matters. As noted many time, a currency’s trend reflects the markets opinion about estimated future real growth rates and real interest rates for the home economy. The $US market is more complex due to its reserve currency status and broad use. It tends to get “risk off” flows in times of crisis but the basic concept still applies.
The US has had strong growth compared to Japan and the EU though its (slightly) higher core inflation reduces the differential. All three areas have negative short and medium term real interest rates even with looming core deflation.
Japan’s deflationary mindset is ingrained and the Euro is getting there. Falling yields in the EUs peripheral countries are getting an extra push from bond traders trying to get ahead of the assumed start of EU QE. The ECB could soak up all the short term bonds of Spain, Ireland, Portugal and a chunk of Italy’s too under a substantial program.
While the US has the better growth rate the bond markets doesn’t expect the Q3 rate of 5% will be reproduced. US bond yields have dived in the past two weeks right along with others. The yield differential narrowed as recent US data, particularly wage data in the December payroll report sowed doubts.
The payroll number was good and the job gain for the year was impressive. That made the year over year average wage gain of a miserly 1.7% that much more frustrating for policy makers. It’s no secret how important a metric wage growth is for the FOMC. It’s been highlighted over and over again. The oil price may be a factor. If prices stay low there could be significant job losses in the oil patch. That sector has much higher than average pay. Losing oil patch jobs could have an outsized impact on average wages through this year.
Skepticism about the wage number dissipated when the US reported a terrible consumer spending number for December. Even with the drop in gas prices, which was huge, a 0.9% drop in spending was a shock and prior month’s growth were cut as well.
If the December wage and spending numbers are the start of a trend there is no way the US will generate the 3-4%+ growth traders dream of. Maybe it’s a blip but if it’s not we could see topping in the USD soon even with the mess in Europe ongoing. 70% of the US economy depends on consumer spending. They can’t spend it if employers aren’t paying it to them.
The strength of the USD may be inhibiting US wage gains at multinational companies. Wages in other jurisdictions get cheaper and more competitive to US workers the more the greenback rises. It would suck if US corporate boards were doing the math that way but it would hardly be shocking.
The bottom line is that the stronger currency and cheaper oil are not the one way good news story Wall St wants them to be. Lousy bottom lines for oil companies and lost sales or thinner margins for exporters will impact earnings. There are reasons for the USD to rise but these moves do become self-correcting when they go too far. Even with the problems the Euro has we are getting close to that point. The $USD could rise further against the Euro while losing ground against other currencies.
Let’s talk about the “runner-up” currency now.
That Other Currency —The Shiny One.
That brings us around to the gold market. My views about gold’s physical market strength have been often stated. That continues to provide bid strength at current and lower levels. It’s important to remember that for many gold is also viewed in currency terms.
Some view that facet of the gold market as a negative for bullion. They’re wrong about that. I think the currency side of the gold market helped build a bottom and pave the way for potential gains this year.
I’ve also noted many times that currency trades are always pair trades. You’re buying one and selling the other. There are a huge number of potential trade pairs, though US$-Euro and US$-Yen are the most popular and closely followed.
Traders and commentators in the US focus only on USD prices. The Dollar is the world’s dominant currency and many people (me included) think of metal prices in Dollar terms. That is not the case for large parts of the world however, including the areas that actually buy most of the bullion. They think in terms of their own currencies and that changes things a lot.
The following two pages include one year charts comparing the gold price in $USD against a number of other currencies. The first page displays charts for large bullion buyers namely China, India and Russia while the second has the two main European currencies (the Euro and Pound) and the Canadian Loonie, a gold (and oil) producer currency. A chart showing the Aussie dollar would look almost identical to the CAD chart.
As you can see, the gold price was essentially flat in Yuan and Rupee terms and a huge win in Rouble terms. That is not a negative for either Chinese or Indian consumers as both are very price conscious. Cheaper is better for them though that state of affairs may not last.
Remember that the Yuan is not really a freely traded currency. The Bank of China controls the trading band and I think it’s made a point of trying to keep it stable to tone down anti-China rhetoric by US politicians. The Rupee has traded down against the US though it’s been relatively stable since Modi’s election. The drop in oil gives New Delhi some breathing room and may allow more interest rate cuts.
Russia is a different story on many levels. It’s been a big gold buyer lately though in the case of Russia its central bank buying not consumers. The chart should make it clear why I viewed recent stories about Russia selling gold with skepticism. Selling gold to buy what exactly? Gold has done as well as the USD against the Rouble. Putin’s gold buying in the past 24 months looks a lot smarter than most of his other activities.
The story is similar in Europe. Gold’s 2014 bottom in Euro terms came right at the start of the year. Bullion is up 19% in Euro terms in the past year, 9% in terms of the Pound and 11% in Canadian and Aussie dollars. In short, gold did a great job as a store of value in the eyes of most of the world’s population.
As we enter 2015 the other dominant theme in the market—disinflation—is cued up to strengthen the trend of gold performance across a range of currencies.
The combination of central bank buying and bond market skepticism about economic growth and inflation continues to drive government bond prices higher and yields lower. If the ECB starts a large QE program the trend will be further underpinned.
Real (inflation adjusted) yields are going negative as central bankers try to cajole borrowers into taking on risk and banks into lending to them. The fact it’s so hard to get lending back on track speaks to the lack of conviction about the future that will make it hard to generate higher growth rates. That’s a problem, obviously, but the market conditions it’s created are a positive for gold.
One of the main knocks against investing in gold is the lack of yield. When viewed in investment (rather than a value store or currency) terms the fact gold doesn’t pay interest or a dividend is a negative. Indeed, one of the chief reasons given for gold slide last year was that the end of QE in the US meant interest rates would rise and the investment case for bullion would crumble.
We’ll ignore the oversimplification of this argument for the time being (its inflation adjusted rates that matter) and stick to the current facts. With short and medium term yields nearing or going below zero in several major bond markets the holding cost argument against gold is severely weakened. There is currently little or no “opportunity cost” to holding bullion in many markets.
In several major EU economies you effectively pay a premium to hold short term government paper because if its negative interest rate. Gold has a higher effective return in these markets even before potential for gains in the gold price itself are factored in. I don’t think it’s a coincidence that gold has held up so well in markets with subdued interest rates and the list of those markets is growing almost daily.
I’m not expecting a near term return of inflation. I wish I was, frankly, as that would be a sign of confidence. Even so, it’s the real interest rate that matters.
Historically, gold has a tailwind as long as real interest rates are negative. I don’t see any western central bank—including the Fed—being brave enough to get ahead of the inflation curve any time soon even if the disinflation ends and we start to see core CPI climbing. It’s just too risky with the weak demand backdrop we have virtually everywhere.
One last thought to leave you with is about the two largest markets for bullion, China and India. Cheap oil is a boon for both of them and helps bring down the inflation rate in both countries. Both lowered interest rates and may drop them more if the economy continues to slow. Real rates are high in China. India may have room to cut without damaging the Rupee further with cheap oil in play.
The one year chart above for the Shanghai exchange shows what a moon shot it’s been. I think we’ll see Shanghai level off as Beijing continues financial reforms and lets some companies fail. That is a good thing. Chinese trader are too fearless for their own good lately and need to learn to price in risk.
I mention this because China’s 2014 gold imports were only two percent below 2013’s. And that is with clearly huge money flows going into the stock market. I wonder what happens if traders get a little spooked and want to move some money elsewhere.
Traders are more skittish now, though still buying. One public company appears to be defaulting on its bonds and there could soon be others. That has generated some profit taking. I can’t help but wonder if we won’t see higher than expected gold purchases heading toward lunar New Year next month. Gong Hay Fah Choy.
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