Gold is trading around $1,100 per ounce, a five-year low, down over 40% from its all-time high in August 2011, and down over 8% this year alone.
According to Bloomberg, hedge funds are net short gold for the first time since records have been kept starting in 2006. Sentiment is abysmal. To paraphrase the brilliant Jim Grant, gold, it seems, has never been more unloved.
All of this is well known to investors. The question is why, and what does a temporary collapse in the dollar price of gold presage? The search for answers takes us on a journey through the inner workings of this most important and least understood market.
The first issue to consider is what’s called the numeraire. That’s a French term used in mathematics and markets. It refers to the yardstick we use to measure other things. If the U.S. dollar is the numeraire, then gold is down measured in dollars. But if gold is the numeraire, then it’s more accurate to say that gold is constant (that’s what a numeraire is) and the dollar is much stronger.
In August 2011, one US dollar got you 1/1,900th of an ounce of gold. Today one US dollar gets you 1/1,100th of an ounce of gold. You get more gold for your money. How you look at it depends on whether you believe gold or the dollar is the better long-term benchmark for wealth. I prefer gold, others prefer paper dollars – take your pick.
Support for this “strong US dollar” view comes not just from gold but from every major currency and commodity in the world. Look at the list of things that are down against the dollar over the past year: sugar, wheat, iron ore, copper, oil, natural gas, Canadian dollars, Australian dollars, the euro, the Japanese yen, and so on.
The only reason the Chinese yuan is not down also is because the Chinese have made a strategic decision to kowtow to US wishes, and maintain a dollar peg as the price of admission to the basket used to calculate the value of the IMF’s world money called SDRs.
Why the US can’t afford a strong dollar again
The point is this is not an age of weak gold; it’s a new age of King Dollar. Therein lies a tale.
The last age of King Dollar started in 1981 with the combined efforts of Paul Volcker and Ronald Reagan to end the monetary confusion of the 1970s. It lasted until the US economy hit the wall in 2007.
Importantly, that age of King Dollar prevailed through Republican and Democratic administrations, and included the two longest peacetime expansions in U.S. history, 1981-1989 (92 months), and 1991-2001 (120 months).
The US could afford a King Dollar strategy because they had strong, continual growth during the decades of the 1980s and 1990s. The rest of the world would benefit from weaker currencies that promoted their own exports.
The new age of King Dollar is different. Now the US is in a period of weak growth, global debt, and currency wars. When the Federal Reserve and US Treasury green-lighted the strong dollar after 2012, they committed an historic blunder. They assumed based on faulty forecasts that the US was returning to trend growth and could afford a strong dollar, as was previously the case.
Instead, US growth has continued to disappoint. Now the US economy itself is flirting with recession because of this infelicitous mix of weak growth and a strong currency.
Meanwhile, the Fed has created asset bubbles (in stocks and real estate) and asset crashes (in gold, oil and currencies) under its misguided policies.
A foreseeable consequence of a strong dollar in a weak economy is deflation. Collapsing dollar prices for a long list of currencies and commodities is the result. The Fed is trying to offset this deflationary tendency with zero rates, but it’s not working.
At best, the forces of deflation and inflation are cancelling each other out. At worst, deflation will start to win this tug-of-war in the months ahead.
In addition, there are technical factors at play when it comes to gold. Once the dollar price of gold sinks to a certain level, leveraged investors such as hedge funds hit their self-imposed stop loss limits and have to sell. Others who bought gold on margin may be forced out of their positions by brokers. Finally, some large selling has been coming from China in response to the stock market crash there.
Hedge funds losing money on stocks sell gold to raise cash to meet margin calls. When hedge funds are in distress, they don’t sell what they want, they sell what the can, and gold fills the bill. All of these factors – stop loss, margin and leverage – add momentum to gold’s downward price movement.
These trends are unsustainable.
The Fed will have to blink when it comes to their much talked about rate hike, or else they will cause a global crash. Look for the Fed not to raise rates soon, perhaps for years. The gold selling by weak hands in China and elsewhere will run its course. Once you’re out, you’re out. The strong hands are happy to buy at these depressed levels.
There’s nothing unusual about a 50% retracement in commodity bull markets. On the long road from $200 per ounce to $5,000 per ounce (or higher), a 50% pullback should be expected. If one takes $1,900 as an interim high, a pullback to the $950 to $1,050 per ounce area would be unsurprising. It looks like we’re just about there.
If the Fed maintains its kamikaze tight money mantra in the middle of a deflationary currency war, then gold and other commodities could go a bit lower. My expectation is the Fed will wake up to the damage done and reverse course; possibly even launching QE4 in 2016.
As this plays out over the next few months, look for commodity and currency markets to hear the message that the Fed will achieve inflation “whatever it takes.” Once that message sinks in, gold will once again shine.
For The Executive Bulletin