Thoughts through the cycle: W4 January ’20

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Gold

  • In September 2018, the FBI recovered the ruby-coloured slippers worn by Judy Garland in the 1939 film ‘The Wizard of Oz’ over a decade after they had been stolen from the Judy Garland Museum in Grand Rapids, Minnesota. The shoes had been insured for $1mn but the insurer, suspecting fraud, reportedly only paid out $800,000 to settle the claim.

  • Aficionados of movie memorabilia venerate the red slippers. Few though remember that ‘The Wizard of Oz’ was seen by some as an allegory for the perceived crushing effects of the gold standard on the US economy: ‘Oz’ represented the standard ounce-measure for gold; the yellow brick road represented bars of gold; the wicked witch of the east represented the New York bankers; the cowardly lion the ineffective Washington politicians and so on.

  • Although the film came out in 1939, hatred of the gold standard in the US was not a new phenomenon. After 1873, silver was excluded from the authorised US coinage and the subsequent perception of the deflationary effect of the gold standard on agricultural commodity prices was a key element in the rise of the ‘free silver’ and ‘bimetallism’ movement in the US Mid-West at the end of the nineteenth century which culminated in William Jennings Bryan’s ‘cross of gold’ speech at the Democrat convention in 1896 in which he described farmers being crucified by the gold standard.

  • Gold, especially gold-as-money, is a topic which still excites extreme views. With the gold standard having been largely abandoned by the early 1930s and the London gold window (allowing convertibility of US dollars to gold at a fixed price of $35 per oz) having closed in 1971, gold-as-money is clearly not a matter for every-day consideration any more. That said, interest in the topic does seem to be on the rise again – if one uses for example the occurrence of think-pieces in the Financial Times as a barometer, albeit an unscientific one. Is talking about gold just a thing for the crazy folk, or is there a genuine reason for the increase in interest in the metal?

  • 2019 was undoubtedly a risk-on year for markets, with the S&P 500 rising nearly 30% excluding dividends. 2019 also saw gold rise 18% and break through the $1350 resistance level which had held since 2013, finishing the year at $1517 (see graph below).

Source: Bloomberg, 17 January 2019.

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • It seems odd that gold, a safe-haven asset, should rally so sharply and significantly at the same time the market resumed its bull run after the 2018 sell-off. However, the rally in gold and US equities occurred simultaneously because they both had the same proximate cause – the dovish turn by the Fed which resulted in financial conditions easing, allowing both asset classes to appreciate.

  • Gold is essentially an asset which lies outside the financial system and therefore has no liabilities against it. One consequence of this is that it offers no yield. As the Fed turned dovish in 2019 and first stopped hiking before then beginning to cut rates, US real interest rates fell sharply. On a relative basis therefore, gold’s impediment of offering no yield became relatively less of a disadvantage. This can be seen in the graph below where the rising gold price (yellow line) is visibly negatively-correlated to US 10yr real rates (blue line). It is notable how the gold price really took off mid-year when it became clear the Fed was going to cut its target Fed Funds rate.

Source: Bloomberg, 17 January 2019

  • 2019 was also the year of peak negatively-yielding bonds. The notional value of global negatively-yielding bonds reached a peak of just over $16 trillion in August (red line in the graph below), as did the spot gold price (yellow line). As a perverse consequence of the world of negative rates and quantitative easing, gold’s yield of zero started to look attractive relative to the growing cohort of negatively-yielding sovereign and corporate debt.

Source: Bloomberg, 17 January 2019

  • What is particularly interesting about the graph above is that while the price of gold moved lower as the stock of negatively-yielding debt fell in late Q3 and early Q4, it effectively ‘decoupled’ from these bonds in November and December and began to rally even as the US equity market started to move vertiginously higher into year end.

  • Two observations can be made here. First, while equities were rallying on hopes of a recovery in global trade, US real rates did not move higher, suggesting the bond market was not interested in the reflation trade. Secondly, in response to pressure on primary dealers because of growing Treasury bond issuance, the Fed in October resumed quantitative easing in the form of $60b of T-bill purchases per month. Unusually, real rates did not increase after this. Real rates remaining low even as the Fed starts to monetise the US deficit appear to be catnip for gold prices.

  • In the past, quantitative easing has been negative for gold as it resulted in real rates rising as the market assumed outright deflation would be avoided. This time, or at least so far, that is not the case. This may in part be because the Fed is simply buying short-dated T-bills rather than the longer-dated treasuries and mortgage-backed securities it previously favoured, as it is responding to problems caused by the US deficit rather than re-initiating an overt policy to stimulate risk-taking in financial markets to promote growth.

  • The US budget deficit exceeded $1 trillion in 2019, and the funding of it has had a number of consequences, not least the Fed having to intervene in the repo market from September onwards. Dollars used to fund the US deficit are dollars ‘sucked in’ from elsewhere.

  • As the effect of the Trump tax cuts made themselves felt both on the US deficit and in the wider Eurodollar market from early 2018 onwards, the DXY dollar index began to appreciate (purple line in the graph below). What is interesting is that gold, often negatively-correlated to the dollar (gold lies outside the financial system so is often priced ‘in terms of’ other currencies, in this instance dollars, so when the dollar rallies gold falls, all else equal), has since 2018 rallied even as the DXY index has appreciated (gold is the yellow line in the graph below).

Source: Bloomberg, 17 January 2019

  • What does it mean if gold rallies and the dollar rallies? If the dollar stays strong even as real rates fall, then it suggests that there is a shortage of dollars in the world, which should be negative for growth. Low real rates from financial repression by central banks also help the gold price as discussed earlier. The shortage of dollars due to the expanding US deficit tightens monetary policy, keeping rates low as well. When the Fed has to start monetising the US deficit due to capacity restraints amongst primary treasury dealers, then worries about the overall quality of fiat money start to surface amongst the gold-standard hard-money types.

  • If there is a shift in the heavy-lifting of growth policies in the coming years from monetary policy to fiscal policy (and the ensuing primary deficits are monetised by central banks as they may well have to be given the large stock of debt outstanding), then expect the drum beat from the gold-as-money crew to grow louder.

  • Ultimately, the job of investing is to be on the right side of price moves sufficiently early to make a reasonable return without having to chase the market into extreme levels of valuation. At the moment, gold is not money. In terms of usage, just over half goes into retail (jewellery and the like). About 10% is used in industrial processes. The rest is accounted for by the investment community, a group which includes central banks who have themselves been more active buyers in recent years. The World Gold Council estimates however that, on average, gold constitutes only around 1% or so of global investment portfolios.

  • If retail purchases currently account for the majority of annual gold transactions, it is fair to say that gold is in general currently treated as jewellery not money. Should that reverse, the price action resulting from the reattribution of value from gold-as-jewellery to gold-as-money would likely be dramatic as asset allocators increase their weightings. Monetary events are however the purview of governments and are rare – the last ‘big one’ was Nixon’s decision to end the dollar convertibility of gold in 1971 precipitating the era of floating, fiat currencies. Understanding how gold interacts with other financial assets is one thing, predicting its fate is another altogether.

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