Gold, The US Dollar, Inflation and the recent global rise in Government Bond Yields

The probability is that gold’s correction from its August high is largely complete, just as treasury yields are likely near or at the terminal phases of their respective rallies. Last Friday COMEX gold futures reached an intra-day low of $1,717 in a significant area of technical support and just above its Fibonacci corrective 38.2% retracement target of $1,690. At the same time, the NYBOT USD futures erased the previous 7 days of losses, beginning last Thursday when they shot up from a low of 89.87 to close on Friday at 90.97.

Around this time last year, near the end of the market crisis I posted an article “The Pandemic is Rolling Around the World Like a Hurricane Leaving Devastated Economies in its Wake” which went into the technical details of the financial market’s near-collapse, most notably of the implosion highly leveraged relative value trades and what was essentially a global dollar short squeeze. At the same time, I explained why the dollar’s rally would not last and why it was a good opportunity to buy gold. You can find it on this link.

So here I am writing again, and in comparison, it seems the latest market drama is more an aftershock compared to the 2020 COVID-quake. Now I will make a case for taking advantage of what looks like the end of gold’s 6-month long correction and potentially the beginning of a major leg to new highs.

The dollar and interest rate spikes (and gold’s decline) appear to have ended, just as the Treasury begins releasing $800 billion of the $1.6 trillion it currently holds in its Treasury General Account (TGA). Treasury Secretary Janet Yellen says they a further $300 billion will be released by this June. According to Mark Cabana a bond strategist at Bank of America, if the the Federal Reserves planned QE is included, the total new dollars entering the banking system could be as much as $1 trillion within the next 60 days and $2 trillion by June. Normally there is only $3 trillion in the entire banking system and around $400 billion in the TGA, but these are far from normal times.

Some relief.

Last week’s Congressional approval of President Joe Biden’s $1.9 trillion relief bill and his promise of a similar sized infrastructure bill later in the year may have been the last straw for bond traders as the market is now pricing in what many now see as increasing odds that inflation will accelerate in the near term. Another worry is the possibility that commercial banks’ ability to buy United States Treasury bills or bonds (UST’s) may soon be sharply reduced. If it happens, it will be because a rule instituted by the Federal Reserve (FED) last year, which excludes from Banks supplementary leverage ratio calculations (SLR), U.S. Treasuries and FED deposits credited to the banks in exchange for treasuries. The rule has yet to be extended past its expiry this March 31 and the Fed has indicated it has not yet decided whether or not it will.

The rule essentially gives the banks the ability to buy a nearly unlimited amount of treasuries, which they resell to the Fed as it continues its latest QE iteration. J.P. Morgan Asset Management helpfully issued a bulletin last year when the rule came into effect, explaining that when a bank sells a UST to the FED, its balance sheet does not shrink when it receives from the FED a deposit in exchange. This is because as mentioned above, treasuries no longer have to be part of the SLR calculation for capital adequacy and, If they were included, the amount of treasuries a bank could buy would be reduced by each additional purchase. In J.P. Morgan’s words “Put another way, for the Fed’s QE purchases to potentially accelerate in the future, the Fed needs banks to have assets it can purchase. So banks need the ability to hold more assets in the first place”. If the exemption is allowed to expire, it may force additional treasury selling as banks re-balance their portfolios just as they would also be limited as to how many treasuries they can buy in the future – thus impairing their role as QE intermediaries. All else considered, it seems a distant prospect that the FED would fail to renew the rule.

For the Bond market, the potential end to the SLR exemption, the imminent TGA Tsunami, US trade and fiscal deficits ad infinitum, growing inflation risks, and until now not mentioned: the $7.7 trillion worth of Federal debt coming due, which will need to be refinanced this year, and the repricing of these compounding fixed income risks was in order. What to do next remains, however, a hard call for the Federal Reserve’s board of governors given America’s sputtering economy, millions jobless and a mass of businesses facing bankruptcy, while at the same time supply shortages, and massive 25.9% broad money growth makes conditions ideal for accelerating inflation.

Powell’s uncertain path

In his semi-annual update on monetary policy last week, Federal Reserve Chairman Jerome Powell warned that “The economy is a long way from our employment and inflation goals and is likely to take some time for substantial further progress to be achieved.” He described the path ahead as “highly uncertain” and noted that the real number of employed Americans was 10 million.

Stephen Roach, a senior fellow at Yale University’s Jackson Institute of Global Affairs and the former Chairman of Morgan Stanley Asia, agrees. He warns that recent trends in US consumer spending suggest that there is little pent up demand left once the COVID crisis subsides.

Mr. Roach notes that while consumption of consumer durables surged 39% May through December 2020, compared to what was lost the prior March and April, consumption of services remains 25% below its peak and is likely to remain depressed. Given services are more than 60% of US GDP, the need for President Biden’s economy boosting $2 trillion ‘Build America Better’ infrastructure plan is apparent. If it passes, it’s hard to imagine many commodities not going parabolic. Think of it this way: if miners and loggers (see lumber & copper charts below) have trouble supplying demand now, how will prices be affected if and when the planned Biden building boom is underway?

Inflation is spreading in both scope and intensity.

Already inflation appears to be spreading in both scope and intensity. Price increases are occurring in everything from transportation, microchips, to housing and food. For example, air freight rates have doubled in the past year, in part because costs used to be kept down by taking advantage of spare capacity on passenger jets. Chip production inTaiwan is being curtailed because of a drought. House price rises are propelled by ultra cheap financing and a shortage of newly built houses.

Commodities are also on a tear as the charts for copper, lumber, oil, food and the GSCI Commodity Index illustrate. Overall, commodity price moves are driven by a general lack of investment in new supply over the past decade and a weaker US dollar. On average, it takes 10 years to build a mine from discovery to production, knowing this, I doubt the materials’ bull market is going to end any time soon.

I have often referred to the correlation between real bond yields and the price of gold. When inflation meaningfully exceeds what fixed income securities pay investors, gold tends to do very well. The real question is while its correlated can it predict future prices or is it more like driving a car using a rearview mirror? The chart below shows how well gold tracks real yields. Most important is that while we can perhaps explain why gold is at a certain level, we can’t really demonstrate that the real yield is continually giving an accurate forecast regarding the future direction of gold’s price.

Gold, Financial Liquidity, and Occam’s Razor

 Michael Howell, a top ranked EM analyst, developed a quantitative, liquidity research methodology when he was research director at Salomon Bros. – years prior to starting his firm Cross Border Capital, He suggests that the evidence shows gold’s price is a phenomenon of financial liquidity. That is when more money is available, its price will be higher, and vice versa. Rather than price gold in terms of fiat or paper money, he says we should view paper money as being priced in terms of gold. The more money is in circulation, the higher will be the price of gold in terms of paper money.

Not M1, M2!

This was the mistake made by many gold investors post 2011, when they assumed QE would cause inflation and increase gold’s price. M1 the monetary base grew massively but there was never a significant increase of money in circulation – M2 – because there was no transmission mechanism for the money the Fed had created. Instead, the Obama administration was reducing spending and the deficit thus slowing M2 growth – the opposite of what would increase money in circulation and underpin a higher gold price.

This time the opposite is true. M2 growth is on an epic and global scale. It’s acceleration actually began with POTUS Trump’s deficit exacerbating tax cuts. Since then Central Banks have been buying government securities like never to before, in order to finance the massive Covid prompted spending (and resulting deficits) by multiple governments.

Fear and Greed

 Warren Buffet famously advised investors to be “fearful when others are greedy, and greedy when others are fearful” and over the years, when making what turned out to be some of my most profitable investments, I have had to overcome my own emotions – that is to avoid getting caught up in the prevailing negative crowd psychology.

One of the more memorable examples is Prime Resources Group. It was developing a mine up in British Columbia’s Eskay Creek area. Gold had been in a bear market for the past four years and Prime’s shares were down about 90% from their highs, so saying it was out of favor is really an understatement. I had carefully analyzed the project and really expected it would do well – enough to recommend it in my financial letter. I also decided to take a position. There was an iceberg order at $1.90 and every time I bought 10,000 shares another 10,000 appeared. I bought 100,000 shares that day which was a lot for me. I really would have felt better if it finally went no offer but the iceberg stayed. I think I went home and to bed after that, even though it was early afternoon.

I didn’t even check on its trading for the next few days. I was waiting for the feasibility study results to be announced so what the shares did before then wasn’t all that material. In reality, with all of the doom and gloom, I may also have been afraid to look. Then after a month or so it just started going up – all the way to $14 a share. As the feasibility was announced, the mine was built and production started. I think if I waited until the market looked better or until the iceberg order was gone, I never would have bought the stock. I would have missed the opportunity.

My point is not to get caught up in the market psychology. And in today’s gold market there is no shortage of fearful investors. Yet there is a very serious case to make for a secular decline in the exchange value of the US dollar, and its use for international trade. Combine this with what appears nearly unstoppable M2 growth, accelerating inflation and in the future; a suppression of interest rates, similar to what occurred following the second world war (when Government debt levels were not quite as high as they are now), and we have a perfect storm which over the years should drive gold’s price dramatically higher.

That’s it. Happy investing.

Neil Maedel