Gold, OMFIF, the Fed, BoJ and Bond Markets!

Precious metal prices rallied last week, with the price of gold climbing back toward USD $1,340 per troy ounce (oz), whilst silver prices rallied toward the USD $20oz level at one point, before giving up some of the gains.
 
As it stands, September is set to be a positive month for the precious metal complex, arresting the decline witnessed in August, which at one point threatened to push gold below the USD $1,300oz level, and did take out USD $19oz in the silver market.
 
The relative strength of gold and silver in the last few weeks is not surprising, with greater uncertainty creeping into markets regarding the potential for an upset in the US election campaign, combining with an uptick (from admittedly low levels) in financial market volatility.
 
Greater question marks about the efficacy of central bank policy interventions (more on this subject below) have also no doubt helped provide a bid for the market, which has oscillated between the high and low USD $1,300 range for most of the last three months.
 
Short-term, whilst we’re encouraged with the recent pick up, we wouldn’t rule out another move lower in the next week or so. Taken as a whole, the past few months’ consolidation and corrective action for USD gold has been relatively healthy, as the chart below (courtesy of an article in the Daily Gold), highlights.

If you want to see the original Daily Gold article that includes the chart above, as well as some charts on gold stocks, then you can access it here.

Looking at the chart though, as you can see, gold has held up between USD $1,300-USD $1,310oz on three occasions between late July and now, whilst silver also looks solid, outperforming gold over the last month or so. Indeed the Gold:Silver ratio fell toward 68:1 by the end of last week, down from the closer to 71:1 levels we saw in late August.

ABC Bullion General Manager Nicholas Frappell, who writes a regular technical and positioning report also sees a fairly constructive outlook for the gold price, noting yesterday (26th Sept 2016), that; “short term a test of the US$1318 level looks likely, however the medium term outlook is turning more favourable with a resumption of targets back towards the US$1400 level. Last week’s target down to US$1275 is still there, and active below US$1351, but looks less likely.”

Note that the relatively healthy technical picture, combined with the numerous macro, market and monetary reasons to want to own gold do not mean investors should rush out today to pile all their money into precious metals immediately.

But it is supportive of the thesis that the primary trend for the sector is bullish, and that investors should treat dips as buying opportunities.

The Seven Ages of Gold
Just over a week ago, we received an excellent 2 page report from the OMFIF, or the Official Monetary and Financial Institutions Forum. Titled “The Seven Ages of Gold”, the report noted that central bank buying and selling of gold falls into seven distinct phases over the last two centuries, and that each has tended to last an average of thirty years.

Should the great shift in net central bank activity (from sellers to buyers) that began around the onset of the GFC mark the beginning of a similar period, its safe to assume that these institutions will, on aggregate be net buyers up until the late 2040s, with OMFIF noting that the shift since 2008 demonstrates “gold’s importance as a bedrock of most countries foreign reserves”.

Despite the steady pick up in buying of the last few years, it is interesting to note that as a percentage of total above ground gold stocks, central banks still only account for some 17% of total gold holdings.

That is well down on where his number was back in the year 2000, when central banks held 23% of all above ground gold stockpiles, and less than half of what this number was in 1970, when central banks owned a full 40% of total gold holdings.

In fairness, there is no iron-clad correlation between rising central bank purchases and rising gold prices, or vice-versa, with the first few years of this secular bull market in precious metals (the early 2000’s up until the GFC hit) seeing large gold sales from central banks, alongside sharply rising prices.

Nevertheless, the OMFIF research is another indicator and reflection of the importance of gold as a strategic monetary asset, perhaps best demonstrated by the table below, which was included in the Seven Ages of Gold report. 

Source: OMFIF, The Seven Ages of Gold

For anyone who is under any doubt as to how the US dollar became the dominant reserve currency in the period surrounding WWII, just look at the table above, and the staggering fact that the US controlled over 75% of total national gold reserves in 1940. Today the US number is just 1/3rd of that.

Countries like China and Russia, despite their massive purchases in the past few years, would officially need to quintuple their holdings from here to match that of the USA.

Still on Central Banks!
Whilst central bank gold buying is always of interest to us here at ABC Bullion, for most of the market, it’s central bank bond buying, alongside other monetary interventions, that gets most of the markets attention, with the last week seeing key meetings held by both the US Federal Reserve (the Fed) and the Bank of Japan (BoJ).

Starting with the Fed, and it was no surprise that they chose not to hike rates, for a multitude of reasons, including the fact that economic data is still fairly soft, with manufacturing data out of the US hitting a 3 month low.

US existing home sales fell -0.9%, whilst housing starts fell short of expectations, even though the NAHB Housing Market Index rose to 65 points for September.

We also think the election will be playing on the mind of the Fed, and even though a 0.25% move (or non-move), will do little to impact the real economy, it could have caused havoc on financial markets, something they’d be particularly keen to avoid at this point in the electoral cycle, no matter how apolitical Yellen and her fellow FOMC board members claim to be.

And you can’t blame them (to some degree), when so central bank obsessed “markets” have become, perhaps best summarized by the image below.

And whilst the above image was the funniest, arguably the simplest (and the best) chart we saw in the aftermath of the FOMC meeting was the one below, which came courtesy of Eureka (you know someone should really make a gold coin like that……oh wait, click here).

As you can see, the chart plots the evolution of the now infamous Fed ‘dot-plot’, and where FOMC members see interest rates as most likely to sit in the coming months and years, as well as the view of the market itself.

Source: Eureka, AMP Capital

As you can see, between March and September of this year, expectations on the future path of monetary policy within the FOMC itself have declined notably, with members now seeing rates in December 2018 at closer to 2%, rather than the 3% level they were indicating just 6 months ago.

If anything, the FOMC is likely to become even more dovish in the coming months, especially if there is a Trump surprise come November, something that is well and truly on the cards now, with Nate Silver giving the Donald a slightly higher than 50% chance of winning, were the election to be held today.

Politics aside, the other headwind to higher rates is the US economy itself, which is now late cycle, and at some chance of rolling over into a recession at some point in 2017.

And whilst there is clearly a battle that is taking place amongst voting members of the Fed as regards the appropriate rate of interest for the US economy right now, we think the more dovish members of the FOMC will end up winning the day. Indeed the market itself (pink line in the above chart) is likely the more accurate predictor of the future path for interest rates. If it is right, then get set for another 4 years of sub 1% nominal cash rates.

Note in the above paragraph I specify nominal rates, for “real” rates are likely to be much lower, owing to the emergence of some truly sticky inflation, which you can see in the chart below, which plots “sticky price CPI”, as well as “flexible CPI”.

Sticky CPI, which is now running at close to 3% per annum, measures price increases for items that are not re-priced frequently (which are deemed flexible). 

Source: Federal Reserve Bank of Atlanta

As you can see, sticky CPI is now running at its highest level in years, approaching a rate of increase last seen just prior to the onset of the GFC. According to the Cleveland Fed, sticky CPI is actually a better predictor of future inflation trends, as it better accounts for inflation expectations (owing to the fact actual prices for sticky items can’t respond as quickly as they can for more flexible items).

If that is right, then higher official inflation at a headline level is just around the corner for the USA. Should that happen in an environment where the Fed is on the sidelines vis a vis rate hikes, then expect assets like precious metals to respond accordingly.

And by accordingly, when it comes to gold and silver, we mean higher prices.

Meanwhile in Japan
Fascination with the Fed notwithstanding, the more interesting developments in central bank land last week undoubtedly took place in Japan, where the BoJ decided to alter their strategy once again.

Yes, Kuroda and company have decided to move beyond the now quaint sounding “QQE”, which stood for qualitative and quantitative easing, and indeed beyond “QQE with negative interest rates”, which is just so January 2016. Now, its “QQE with yield curve control”, the name the market is giving for the latest “policy development” emanating from the BoJ.

In essence, the BoJ has decided to keep short-term rates unchanged for now (though still negative), as well as removed any maturity restrictions around which bonds they can buy or sell, instead making the commitment to “control” and ideally steepen the yield curve, with a 10 year JGB rate set around 0.00%.

It doesn’t take too much deep thinking to realize how difficult a task the BoJ has set itself. After all, they have left themselves open to potentially unlimited money printing/balance sheet expansion, as any “market” based sell off in the JGB market will require them “step in”, as a buyer of last resort.

On the flip side, should yields fall, and the 10 year trades below 0.00%, then the BoJ will theoretically need to stand aside, and indeed potentially sell JGBs into the market, in order to maintain “yield curve control”.

Condemnation of the latest move was swift, with the following article in Zerohedge well worth the read, quoting criticisms from CLSA, Deutsche Bank and Goldmans.

There’s nothing we can say that hasn’t been covered in the article linked in above, except maybe to pose the question that we’d like to know what can it really say about the health of the global economy when a true economic titan like Japan is effectively committing to making money worth less than zero (as in worth less than worthless) until at least 2026.

We aren’t sure, but nothing good is good our guess!

Are Central Banks out of Ammo?
Uncertainty, and declining confidence regarding the latest policy developments from the worlds most important central banks has been on the rise for most of 2016, perhaps best demonstrated through the rise in the price of gold.

With growth rates still low around the developed world, trade volumes declining, and income inequality worsening, more and more people are now asking the question of whether central banks are out of ammunition!

The question mark regarding the lack of ammunition was certainly the gist of the following article, which appeared in Marketwatch, in the aftermath of last week's BoJ meeting.

We for one aren’t buying it for a second. Central banks have plenty of ammunition left. The problem (as it has always been) is that they have no way of deploying it “safely”, by which we mean that whilst they certainly can, and likely will use ever more unconventional policy in the years ahead, the negative consequences of such policy are only going to get worse.

As regards what is next, there is no question that negative rates are still being considered in the United States, with the latest Brookings update from ex-Fed chair Ben Bernanke (click here to read), making it clear that helicopter Ben thinks it is far too soon to place the NIRP gun back in its holster.

Given the Fed is something of a laggard when it comes to NIRP, there is clear potential for nominal rates to go deeply negative in not only there the US, but in Europe and in Japan also.

Personally we think one must have to have a PHD, and have spent a long time in a financial ivory tower, to argue that NIRP is ever a good idea, and even more so to argue that either NIRP or higher inflation targets can merely be “viewed as alternative methods for pushing the real interest rate further below zero”, as Bernanke contended.

Not that I think it's a good idea, but people have learned to live with inflation, and the gradual reduction of the purchasing power of their money over time. NIRP on the other hand destroys confidence, with low to negative rates if anything encouraging people to save more not less, as the following headline from the Wall Street Journal suggests.

Clearly Bernanke is no fan of behavioural economics.

NIRP does more than ruin confidence at a household level, it also destroys, or at least seriously disrupts bank operating models, especially in an environment where they were paying nothing or next to nothing for a large share of their deposit based funding.

What is worse is that NIRP, in practice, can only be meaningfully implemented alongside a ban on physical cash, as savers will increasingly flock to safe deposit boxes (and gold, diamonds, art) if they are punished with negative rates.

Ban cash and, as we’ve discussed before, financial repression becomes financial tyranny, though this of course has not stopped an ever greater number of establishment economists and policy specialists who are all of a sudden studying the “advantages” of eliminating cash.

Useful idiots!

In short, as citizens, employees, business people, savers and investors (or a combination of the above), be in no doubt that central banks are not in anyway out of ammunition.

More important than understanding that though, is understanding that we are all at risk of getting hit by the “friendly fire” of our economic high priests in the coming years, no matter how benevolent their intent may be.

Moving on from the Fed (sort of!)
Market rebalancing is one of the key reasons we are bullish precious metals over the next few years, with Bank of America Merrill Lynch research from early 2016 indicating that real assets had never been as cheap relative to financial assets, as they were coming into this year.

This is no surprise when one considers the huge rally we’ve seen in equity markets since the nadir in early 2009, nor the seemingly unstoppable bull market in bonds, that dates back to the start of the 1980s.

That bull market in bonds is perfectly captured in the table below, which shows the return (by decade), in developed bond markets from the 1940’s onward.

Unbelievably, and I can’t stress the definition of that word enough, not one developed market has had negative returning decade since the end of the 1970s.

Despite the government largesse, profligacy, dishonesty and waste we are all witness too daily, I personally have literally never lived through a decade where lending money to the government hasn’t been profitable!

Indeed the entire period since the end of 1970s to today has been one unstoppable bull market, so strong and long-lasting that the average investor (all of whom, myself included, suffer from recency bias) can’t easily picture another world.

That is despite the fact that even the most amateur student of market history would know that there are periods, like the one that from the 1940’s through to the late 1970s, where real returns for lending to profligate, inflation seeking sovereigns are negative!

Imagine that!

This very subject was covered in a report by Deutsche Bank recently, with an article on MarketWatch discussing why the 35 year party for bonds may end soon, with Deutsche going so far as to say that; “Put bluntly the best realistic scenario for financial stability in the new era is that bond holders around the world see a slow real adjusted haircut over several years, probably over at least a couple of decades.”

Robert Gottliebsen of Eureka, commenting on this report, noted that the next couple of decades will likely see lower real growth, higher inflation, and lower corporate profits to go along with potentially negative real returns in bonds.

If that isn’t an argument for owning physical precious metals, then I don’t know what is.

As for what else to put into a portfolio – it’s all a matter of balance, as, despite the fact we’ll see potentially lower profits in the coming years, and the fact that valuations are also well on the high-side (relative to history), investors will also need to account for the fact that saving itself will continue to be punished, with negative ‘real’ rates.

This way of thinking was recently illustrated by Stanley Fischer, who, in an interview with Bloomberg, when discussing the impact of negative rates, observed that whilst low rates were bad for savers; “we have to make trade-offs in economics all the time and the idea is the lower the interest rate the better it is for investors.”

Clearly, central banks across the developed world, including the Fed, are going to continue with their clear preference for higher asset prices compared to saving and investment, no matter how divorced they are from the underlying economy they are meant to represent!

Until next time,
Jordan Eliseo

Disclaimer
This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.