Inflation Bomb Set to Blow

Precious Metals Commentary

Gold weakened as markets focused on the easing of lockdown restrictions in some countries and continued central bank support, trading down from $1,729 at the start of the week to $1,690 as we write.

Despite the weakness, it is positive that gold continues to hold above the $1,680 level. Silver was also off for the week following gold’s move and trading just under $15.

The Aussie dollar ends the week up a mere three quarters of a cent, which combined with USD gold price weakness caused Australian gold to drop temporarily below $2,600, a move of near $100 for the week, currently trading at $2,622.

Aussie silver also came off and got below $23 and is currently at $23.40.

Respected bullion market expert, Matthew Keen, says that gold price volatility will be a feature of the market going forward. He noted that while the move from $1,300 to $1,500 was steady and controlled, the move from $1,600 to $1,750 was less orderly and he said that as we surpass the 2011 all-time high and break the magic $2,000 mark the market will be fraught with dislocations and he can see “a very volatile scenario where $50 [price] gaps become the norm”.

Inflation Bomb

With the US Federal Reserve saying this week that it was “committed to using its full range of tools” investors are becoming increasingly wary.

We thought Chris Manuell from Jamieson Coote Bonds expressed it well by saying that the Fed supporting asset prices does not replace business’ cash flows or fortify their balance sheets and that is was “just a band-aid on a bullet wound”.

Global asset manager PIMCO said that as a result of the Fed’s unprecedented actions they were projecting the Fed’s balance sheet to reach a peak of around $8.5 trillion. While the aggregate number is huge, given the size of the US economy it comes out at about only 40% of the US’ GDP.

We used the word “only” because comparing the US central bank’s actions in percentage of GDP terms to other countries, as the chart below from Bianco Research does, shows that they are well behind the master of QE – Japan – and also little ol’ Australia.

 
Chief Global Strategist for JP Morgan compared the huge increase in US government debt, and monetisation of it by the Federal Reserve, to the classic Roadrunner skit where the Coyote’s box of ACME dynamite fails to get the bird but then blows up when the Coyote goes to check on it.

He says because we didn’t get any inflation following the money printing during the Great Financial Crisis, most economists and policy makers think that the inflation bomb will never go off. However, he says the coronavirus induced recession and money printing gives another opportunity to ignite the bomb.

While the inflation bomb may not blow up this time either, he says “investors would still be well advised to structure their portfolios with an eye to the possibility that it could” and recommends real assets, including precious metals, as they serve an important role in protecting a portfolio against the risk of inflation.

New Super-Sovereign Global Currency

Is it coincidental then that this week Wang Zhenying, the president of the Shanghai Gold Exchange, called for a new super-sovereign currency to counter the global dominance of the US dollar?

Given the central role US dollars play in global trade, actions by the US to deal with its domestic problems impact the exchange rates and trade of other countries.

Zhenying said that “when the Fed turns on the liquidity tap, the U.S. dollar will, in theory, be in a long-term depreciatory trend” and that gold’s gains should be sustained.

While China doesn’t want to be hamstrung by the US dollar, nor vulnerable to potential U.S. sanctions, it also doesn’t want its own central bank to be constrained by a gold standard.

Zhenying acknowledged that gold was “one of the most ancient forms of money” but said that as its supply was finite it limited any role it could have in global trade.

Many would argue that gold’s limited supply is the whole point, providing a value anchor to help constrain central bank largess. We note that a gold standard does not constrain legitimate expansion of money by commerical banks to facilitate trade so Zhenying claims are without merit. For those interested in exploring in detail how a non-central bank gold based monetary system would operate, we recommend The Theory of Free Banking: Money Supply under Competitive Note Issue.

Another Bullion Bank Bites the Dust

This week Scotiabank finally pulled the plug on its precious metals business. It is another marker in the decades long consolidation in bullion banking and significant in two respects because of its history going back to its formation in 1684 as Mocatta Bullion and the fact that it is one of the five clearing banks and one of the 12 market makers in the London gold market.

Scotiabank was a significant player in the gold market and this exit can be traced back to 2017 when a US refinery it was lending gold to got implicated in a multibillion-dollar money laundering scandal involving smuggled gold from South America.

When it failed to find a buyer for the bullion arm Scotiabank scaled down the business but delving into its annual reports reveals that the decline in the bank’s bullion activities was in place before 2017 after volumes flatlined in the years following gold’s peak in 2011.

Source: Scotiabank annual reports; note that lack of precious metal trading loan data prior to 2010 is due to lack of disclosure in the annual report and does not indicate there were no loans made in those years.

Basel 3 and other regulations have put pressure on bullion banking margins and reduced interest in gold by investors after 2011 has further intensified competition. While Chinese banks have been stepping into the gold market globally, this move is likely to allow HSBC and JP Morgan to further consolidate their dominance in the London gold market as their large balance sheets enable them to provide credit to gold miners, refiners and fabricators.

Scotiabank’s withdrawal from precious metals will, we think, be seen as ill-timed in hindsight as our view is that a new bull market in gold is just starting. The World Gold Council reports that COVID-19 has fuelled safe-haven investment demand for gold, with gold-backed ETFs attracting huge inflows of 298 tonnes in the first quarter of 2020, pushing global holdings to a new record high of 3,185 tonnes.

Not surprisingly, jewellery demand dropped dramatically but it was offset by investor buying.

Supporting our opinion that the gold move to-date has mostly been institutional in nature, rather than retail (from a global perspective at least – at ABC Bullion we continue to see broad ranging investor interest), a recent survey by Gallup in the US had only 16% of Americans thinking gold was the best long-term investment.

This is down from 34% in 2011 and shows the potential for continued strength in gold and silver prices as more people wake up to what the Fed’s “full range of tools” means for the purchasing power of their bank deposits.

Until next time,
 
John Feeney and Bron Suchecki
ABC Bullion
 
If you have any questions or feedback about this week’s report, we would love to hear from you. You can contact John Feeney (@JohnFeeney10) and Bron Suchecki (@bronsuchecki) directly on Twitter, otherwise please feel free to send us an email at [email protected], or call us during trading hours on 1300 361 261.

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