For nearly the last five years, we have seen events that were the first of their kind in modern history, from the credit crunch to the East emerging at the expense of the developed world. The oil price has risen to $145/barrel (bbl), fallen to $35 and then steadily moved up to the current $108/bbl. We have seen sovereign debt levels rise to the point where, if they were individual's loans, the individual would have been bankrupted long ago. We have seen governments all over the world try to stimulate their economies to resurrect the spending powers of their embattled consumers. We have seen the developed world inundated with freshly printed money from central banks as deflation hit asset values, reducing the velocity and the volume on money. After four-and-a-half years, developed world governments are seeing clearer signs of a recovery in the U.S. but not in Europe. The world has just averted a banking crisis that may or may not reappear. Banks are still hesitant to lend and when bailed out with cheap money, the banks put that money straight into safe government bonds, so it does not reach the overall economy in the proper doses. That’s why the Federal Reserve is still fearful of deflation!
So our first questions have to be:
- Are we returning to the past era of growth and growing wealth?
- Is current and impending structural damage so great that it is just not in the cards, as we stagger irresistibly toward the next financial crisis?
All of us want the economies of the developed world to recover, consumers to begin spending again and for everyone to be wealthier than we were last year. Certainly, the media tries to squeeze every ounce of optimism out of the smallest statistic. Last week we saw treasury yields rise, signaling that investors were moving out of those and into the equity market—a normal start to a bull market in equities. And that has set markets off to the upside. But now we hear certain banks telling us that the developed world economies are underperforming in 2012, which April reports will confirm.
Tied to this is the now generally accepted concept that an economic recovery is bad for the gold market. We hear that repeated so often that some may start believing it. We are hearing more and more market observers suggesting that gold may have had its day as the U.S. recovery looks a healthier than it did before.
For you, the gold investor, the pertinent question has to be: "Has gold entered a bear market?"
A look at recent history seems pertinent here. A look at the recent history going back to 2005 saw the gold price starting its rise. Developed world economic conditions were terrific, with growth solid and the consumer—on whom the U.S. economy relies for 70% of its drive—was living now and hoping to pay later. It was an equity bull market of note, but the gold price was rising. Was there any relationship between the two? If anything, where the developed world has pertinence to the entire gold world, investors in the developed world were buying gold because they had a huge amount to invest. And all markets looked in rude health right through to August 2007. Then the credit crunch struck and equity markets dove heavily. The gold market trading around the $1,200/ounce (oz) level took a dive too, falling back below the $1,000/oz level.
Did the gold price have an inverse relationship with equity markets then? No: All investors suddenly found the amount they had to invest was hit buy the credit crunch in one way or another. It was the first time that markets fell, not on a poor future but on investor distress. The significant feature was that the gold market and the equity markets did not move inversely to each other. So why all of a sudden are commentators suggesting it is obvious that gold should fall when equities rise? A look at what is happening in the U.S. financial markets may be helpful at this stage.
The Federal Reserve
The Federal Reserve, in its more skilled but less definitive communiqué, implied to the world that it is not contemplating more QE but has not taken it off the table. Sadly, the days are gone when you say what you mean and mean what you say. But this was enough for the financial community to read into it—the recovery is gaining traction and that the future has brightened for the economy and the dollar. During the last week the price of long-term treasuries fell raising the yield. Yields on 10-year U.S. treasuries moved from 1.949% on March 6 to 2.866% on March14. This is symptomatic of the start of the rise in the equity markets, which is what we are seeing now.
The U.S. dollar strengthened, but don't think for a moment that this is going to be due to an improvement in the balance of payments. That remains, as ever, out of balance with a systemic deficit countered by the belief of foreign investors that the U.S. treasury market is the safest place to keep ones surpluses in this world. These foreign investors may have to face losses on their long-term treasuries, if the Fed buying of long-term bonds is insufficient to counter investors selling these treasuries to get into the equity markets. This leaves the market wrestling as equity market investors push long-term interest rates up by selling treasury bonds, and the Fed is buoying these bonds by buying them, pushing interest rates down. Who will prove to be the stronger force?
The U.S. Dollar
As treasury bond interest rates rose (leaving the Fed's efforts in their wake) the dollar becomes both more attractive and also a threat to the profitability of the carry trade. These traders are sensitive to the interest rates patterns and are a large force. We attribute this week's dollar strength to these flows. Can it last? Yes it can, but as long rates rise, the bond market prices fall and foreign investors see the value of their holdings fall. Such losses are treated as losses, prompting foreign investors to sell these bonds as well.
In turn, this gives the Fed a major dilemma because the balance of payments depends on the inward flow of surpluses to keep the dollar healthy. Consequently, the backward and forward dollar flows are not a vote of confidence but short-term opportunity that will prove capricious.
Fundamentally the structure of the balance of payments is detrimental to the value of the dollar, and this long-term trend will assert itself after short-term forces dissipate.
Traders are trying to translate the short-term strength of the dollar to a weakness in gold. Their influence is short term.
Julian Phillips, Gold Forecaster
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